Calculate the Cost of Preferred Stock

Calculating the Cost of Preferred Stock

To determine the cost of preferred stock, crucial for evaluating investment opportunities and for calculating the Weighted Average Cost of Capital (WACC), you will require specific financial parameters. This financial metric, represented as Rp or kp, reflects the rate of return expected by investors.

Essential Inputs for Calculation

The formula to compute the cost of preferred stock is straightforward: Rp = D / P0 or k_p = DPS / P. Here, D or DPS represents the annual dividend per share paid on the preferred stock, and P0 or P denotes the current market price of the preferred stock per share.

Step-by-Step Calculation

Start by identifying the annual dividend paid on the preferred stock and the current market price per share. Use these figures in the formula Rp = D / P0 to calculate the cost. For example, if the dividend is $4.00 and the stock is priced at $80.00 per share, the cost of preferred stock would be 5.0%, calculated as $4.00 / $80.00.

This calculation provides a static snapshot based on current prices and does not account for potential growth in dividends. If the dividend is expected to grow, adjustments to the formula might be required, influencing the calculation outcome.

How to Calculate the Cost of Preferred Stock

Understanding the Basic Formula

The cost of preferred stock is crucial for evaluating the overall expenses that a company incurs for its financing. This cost can be computed using the formula Rp = D / P0, where D represents the annual preferred dividend and P0 denotes the market price per share. This straightforward method provides a clear view of the preferred stock's yield based on current market values.

Step-by-Step Calculation Process

Begin by identifying the preferred dividend per share, often noted as DPS. Following this, locate the current market price per share of the preferred stock. The cost of preferred stock is then found by dividing the DPS by the market price per share. This computation reflects the yield as a percentage, similar to the calculation method for perpetuities in bonds and other debt-like instruments.

Applying the Calculation in Practical Scenarios

Consider a scenario where the preferred stock offers a fixed dividend of $4.00 per share and its market price is $80.00. The calculation would be Cost of Preferred Stock = $4.00 / $80.00 = 5.0%. This result helps investors understand the return they would earn from their investment, assuming the current dividend and price remain constant.

Conclusion

Calculating the cost of preferred stock is a valuable skill in finance that aids in investment evaluation and corporate financial planning. By consistently applying the mentioned formula, financial professionals and investors can assess the attractiveness of preferred shares in comparison to other investment opportunities.

Calculating the Cost of Preferred Stock: Practical Examples

Example 1: Fixed Dividend Preferred Stock

To calculate the cost of preferred stock that pays a fixed dividend, use the formula: k_p = \frac{D_p}{P_p}, where k_p represents the cost of preferred stock, D_p is the annual dividend, and P_p is the current price per share. For instance, if a preferred stock pays a fixed annual dividend of $5 and is currently priced at $50 per share, the cost of the preferred stock is k_p = \frac{5}{50} = 0.10 or 10%.

Example 2: Perpetual Preferred Stock with Par Value

When dealing with preferred stock issued at par value, the formula remains similar: k_p = \frac{D_p}{P_0}, where P_0 is the par value. Suppose a stock with a par value of $100 pays an annual dividend of $7. The cost of this preferred stock is k_p = \frac{7}{100} = 0.07 or 7%.

Example 3: Preferred Stock with Discounted Selling Price

If the preferred stock sells below its par value, for example at $95 while the dividend remains at $7, the cost is calculated as k_p = \frac{7}{95} = 0.0737 or approximately 7.37%. This calculation shows how a decrease in selling price can increase the cost of preferred stock.

Example 4: Growing Dividend Preferred Stock

In rare cases where preferred dividends may grow, the Gordon Growth Model can be adapted: k_p = \frac{D_{p0} \times (1+g)}{P_p} + g, where g is the growth rate. If D_{p0} is $4, the growth rate is 2% (0.02), and the current price is $40, the cost is k_p = \frac{4 \times 1.02}{40} + 0.02 = 0.122 or 12.2%.

Example 5: Callable Preferred Stock at Premium

For callable preferred stock, consider any premium at redemption. If a $100 par stock is callable at $110, and the dividend is $7, assuming it’s called in 5 years, adjust the calculation for premium redemption: k_p = \frac{7}{105} + \frac{110 - 100}{105 \times 5} = 0.0667 + 0.0190 = 0.0857 or 8.57%.

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Calculating the Cost of Preferred Stock

Understanding how to calculate the cost of preferred stock is crucial for financial analysis and investment decisions. Sourcetable streamlines this process. Simply input the necessary data, such as the preferred dividend and stock price, and ask the AI. The formula Cost of Preferred Stock = (Preferred Dividend / Price of Preferred Stock) swiftly computes using the AI's capabilities. This results not only in accurate calculations but also in detailed explanations of each step in both spreadsheet and chat formats.

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