How to calculate cost of preferred stock

This post will educate you on on how to calculate cost of preferred stock and also to understand what it is all about.

Preferred stock is a hybrid stock which show debt and features of securities and common stock.

Preferred stock usually carries a fixed commitment on the part of the issuer to make periodic payments just like debt instruments.

On the hand, preferred stock have have precedence over common stocks, over payment of the invested funds on liquidation of the business.

Thus, preffered stocks are more risky to the business than common stocks but is less risky than bonds.

The cost of preferred stocks could be said to be returns which investors expect to recieve on the funds provided and this approximates the effective yield.

Below is the formula to calculate cost of preferred stock.

Cost of preferred stock = preferred dividend/new price of dividend 

With the above preffered stock formula, you easily calculate cost of preferred stock.

The amount of preferred stock dividends that must be paid each year before earnings can be distributed to common face stockholders.

The preferred stock dividends are paid out of the firm after tax cash flows, thus it it is not necessary to do a tax adjustment.

How to calculate cost of preferred stock

how to calculate cost of preferred stock

Using ABC plc as an example to calculate cost of preferred stock.

The company ABC plc is contemplating the issuance of 12 percent (12%) preffered stock.

The stock is expected to sell for N33.00 per share value.

The cost of issuing and selling the stock is expected to be N3.00 per share.

We’re to determine the cost of preffered capital, assuming the annual dividends is N6.00 per share.

The Calculation

Using the formula KP = DP/NP

Kp is for cost of preferred stock, DP is preferred dividend and NP is new price of dividend.

So we go on to say  -6.0/33-3 which equals 20%.

Kindly note that you’ve to deduct the floating costs of N3.00 per share from the selling price of the stock.

When it comes to calculating cost of newly issued common stock, it is quite different on how to calculate cost of preferred stock.

The cost of newly issued common stock is the rate of returns that must be earned on funds raised from selling the stock to make the action worthwhile.

The cost of new issues of common stock is calculated from the formula;

Cost of New Issue (Ke) = Divided yield + Growth / price of stock x (1- floating percentage) 

Where:

Ke = Cost of New Issue

F = Gross price of the stock

Po = Gross price of the stock

g = Growth rate of dividend

Do = Dividend and yield

The ratio of share price to earnings per share is useful as a guide for the pricing of new issues, in addition to using it as a measure of the cost of equity.

Below is the calculation of newly issued common stock.

Example; Assuming a manager decides to issue shares of N4 with a dividend yield of 25% and floating percentage of 10%. Determine the cost of the new issue.

The Calculation

The cost of capital would be; 4 x .25/ 4(1- 10) + 0.5

This equals 32.8%

Using the example above, to calculate cost of preferred stock and also newly issued common stock, an investor in the above stock would ideally expect a rate of return of 30% on the sharing, assuming there are no flotation costs.

However, because of flotation costs, the firm must earn about 32.8 percent or more.

If the firm earns this new rate of return on project financed by new stock issues, their earnings per share and the expected dividend can be maintained.

The growth rate of earnings and dividend will be maintained and as a result of all these, the price per share will not decline.

Cost of capital is very important in appraising the value of a business, the concept of cost capital could be viewed from the aspect of it’s opportunity coat. With this i conclude this post on how to calculate cost of preferred stock and also newly issued common stock.

Leave a Comment