Stocks represent a share of ownership in a company and a right to part of the company's earnings. Companies can issue two types of stock: common stock and preferred stock. Both operate similarly, but preferred stock entitles the holder to receive fixed payments, known as dividends, that take priority over those of common stock. Furthermore, if a company needs to liquidate, holders of preferred stock receive payments before those who hold common stock, though bondholders precede preferred stockholders.
Companies issue preferred stock to fund initiatives such as product development and expansion. Preferred stock is an attractive option for companies because it allows them to raise capital while limiting the control they give their shareholders. Unlike common stockholders, holders of preferred stock do not get voting rights, which means they have less influence over company decisions and activities.
While preferred stockholders do get consistent dividend payments, companies have the right to defer those payments if they encounter financial hardships and find themselves cash-restricted. In this regard, preferred stock offers companies more flexibility than bonds, which are governed by more rigid contracts. Preferred stock may also be callable or convertible, which means that the issuing company is given the option to purchase its shares back from holders (typically at a premium) or convert the shares to common stock.
Calculating the cost of preferred stock
Preferred stocks are issued with a fixed par value, and they pay dividends to shareholders based on a percentage of that value at a fixed rate. The following formula can be used to calculate the cost of preferred stock:
Where:
Let's say a company's preferred stock pays a dividend of $4 per share and its market price is $200 per share. If the cost to issue new shares is 8%, then the company's cost of preferred stock is:
Importance of determining preferred stock cost
Understanding the cost of preferred stock helps companies make strategic decisions for raising capital. For example, if a company can raise money by issuing preferred stock and bonds with respective costs of 2.2% and 4.2%, then it might favor the preferred stock, which comes at a lower cost. Cost, however, is just one factor companies must consider when deciding how to raise capital. There are other elements, such as borrowing terms and related restrictions, which must also be taken into account when determining how capital will be raised.
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