Preferred Stock Cost Calculation: Using Perpetuity Dividends

Imagine a company needs to raise money, but it’s looking for a different approach than issuing common stock or taking out a traditional bank loan. One option they might consider is issuing preferred stock. Think of preferred stock as a bit of a hybrid investment, sitting somewhere between bonds and common stock. It offers some features of both, and its cost is calculated in a way that reflects these unique characteristics.

One of the defining features of preferred stock is its dividend payment. Unlike common stock dividends, which can fluctuate and are not guaranteed, preferred stock dividends are typically fixed. This means that as a preferred stockholder, you’re promised a set payment amount at regular intervals, often quarterly. This predictability is a key attraction for investors seeking a steady income stream. And this is where the idea of perpetuity comes in.

Perpetuity might sound like a complicated financial term, but it’s actually quite straightforward. It simply refers to something that continues indefinitely, forever. In the context of preferred stock dividends, we often treat them as if they are a perpetuity. Why? Because preferred stock typically doesn’t have a maturity date, meaning the company isn’t obligated to pay back the principal amount at a specific time, and the fixed dividends are expected to continue indefinitely, as long as the company is financially healthy and continues to issue preferred stock.

Now, how do we figure out the cost of this preferred stock for the company issuing it? Essentially, the cost of preferred stock is the return the company must provide to preferred stockholders to make it an attractive investment. Since the dividends are like a perpetual stream of payments, the calculation becomes quite simplified.

Think of it like this: if you are going to invest in preferred stock, you want to know what kind of return you can expect. This return is going to be primarily based on the dividends you receive relative to the price you pay for the stock. From the company’s perspective, the cost of issuing preferred stock is essentially this required return that investors demand.

The formula for calculating the cost of preferred stock is surprisingly simple, thanks to this perpetuity characteristic. It’s essentially the annual dividend divided by the market price of the preferred stock. Let’s break this down.

First, we need to determine the annual dividend. Sometimes, the dividend is quoted as a percentage of the par value of the preferred stock, and sometimes it’s given as a dollar amount per share per quarter. If you see a quarterly dividend of, say, one dollar per share, you would multiply that by four to get the annual dividend of four dollars per share. If it’s given as a percentage, for example, a 5% dividend on preferred stock with a par value of one hundred dollars, you would calculate 5% of one hundred dollars, which is five dollars, and that would be your annual dividend per share.

Next, we need the market price of the preferred stock. This is simply the price at which the preferred stock is currently trading in the market. You can find this information from financial websites or brokerage platforms.

Once you have both the annual dividend and the market price, you can calculate the cost of preferred stock. You divide the annual dividend per share by the market price per share. The result, expressed as a percentage, is the cost of preferred stock.

Let’s take a quick example. Imagine a company issues preferred stock that pays an annual dividend of five dollars per share, and this preferred stock is currently trading on the market for fifty dollars per share. To calculate the cost of preferred stock, you would divide five dollars by fifty dollars. This gives you 0.10, or 10%. So, in this example, the cost of preferred stock is 10%.

This 10% represents the effective cost to the company for using preferred stock financing. It’s the rate of return that investors are requiring to invest in this particular preferred stock, given its current market price and dividend payments. Factors like overall interest rates in the economy, the company’s creditworthiness, and the perceived risk of the preferred stock can all influence the market price and, consequently, the cost of preferred stock. If market interest rates rise, or if the company’s risk profile is perceived to increase, the market price of the preferred stock might fall, which in turn would increase the cost of preferred stock for the company.

In essence, calculating the cost of preferred stock leverages the predictable, perpetuity-like nature of its dividend payments to provide a straightforward measure of the company’s financing expense related to this type of equity. It is a key metric for companies when evaluating different financing options and for investors when assessing the attractiveness of preferred stock investments.