Cost of Preferred Stock

he cost of preferred stock is calculated slightly differently for already issued preferred shares and preferred shares that are just being issued.

Cost of Existing Preferred Stock

Most preferred shares pay a dividend as a percentage of the face (par) value of the shares. For example, preferred stock with a par value of $50 that pays a 5% annual dividend will pay an annual dividend of $2.50, or 5% of $50. The dividend as a percentage of par is established when the preferred stock is issued. Although the dividend needs to be declared by the Board of Directors each time it is due to be paid, dividends on preferred stocks are paid very reliably.

Because preferred dividends are a distribution of income and not an expense, they are not tax-deductible. Therefore, the calculation for the cost of preferred shares does not include an adjustment for taxes.

The cost of existing preferred stock is a function of the annual cash flow in the form of dividends and the market value of the preferred stock.

Since the amount of the dividend is set when the preferred stock is issued, the numerator will not change over time. However, the cost of the preferred stock will vary from time to time because the denominator will change with the changing market price of the preferred stock.

Cost of Newly-Issued Preferred Stock

The cost of newly-issued preferred stock is calculated differently from the cost of existing preferred stock because the cost of newly issued preferred stock uses a different amount in the denominator. For newly issued preferred stock, the cost is calculated using the net proceeds from the issuance in the denominator.

The net proceeds are calculated as the market price of the shares minus any flotation costs incurred. Net proceeds are the amount of cash that the company receives after paying for the costs of selling the newly issued preferred shares.

The formula for the cost of new preferred shares is:

Pay attention to the difference between the cost of existing preferred stock and the cost of newly-issued preferred stock.

• The denominator when calculating the cost of existing preferred stock is the current market price of a share of stock.
• The denominator when calculating the cost of new preferred stock is the net proceeds per share received from selling the new issue of stock after deducting the issuance costs.