What the cost of preferred stock is, and why it is the easiest one
Preferred stock sits between debt and common equity. It pays a fixed dividend, it has no maturity date, it ranks ahead of common stock in liquidation and behind all debt, and its dividend is normally cumulative — skipped payments accrue and must be caught up before common shareholders receive anything. Those features make it a perpetuity: a level payment stream with no end.
The valuation of a perpetuity is P = D ÷ R, so solving for the rate gives R = D ÷ P. That is the entire formula. There is no discount factor to raise to a power, no maturity to solve for, and no growth term, because the dividend never grows. Compare that with the cost of equity, which needs a beta and a risk premium, or the Gordon growth model, which needs a growth rate you cannot observe.
Two adjustments turn the raw yield into a cost of capital. First, use net proceeds, not the gross price, when you are pricing a new issue: if underwriters take 5% of a $100 share, the company receives $95 and still owes the full dividend, so its cost is higher than the yield an investor earns. Second — and this is the point people most often get wrong — apply no tax factor at all. Preferred dividends are distributions of after-tax income, so unlike the after-tax cost of debt there is no (1 − t) multiplier. That single asymmetry is why preferred stock, despite paying a lower stated rate than common equity requires, is often more expensive to the issuer than debt of a similar rank.
The formula, term by term
Dp — the annual dividend per share. Prospectuses state a rate on par: a 6.50% Series A preferred with a $25 par value pays $25 × 0.065 = $1.625 a year, usually as four quarterly payments of $0.40625. Brokerage screens more often quote the dollar dividend directly. Either input works here, and the one error to avoid is entering a quarterly figure where an annual one belongs, which understates the cost by a factor of four.
P0 — the price. Which price depends on the question. Valuing preferred already outstanding, or estimating the market's required return, calls for today's traded price. Pricing a new issue calls for the expected offer price. The two diverge in practice: a legacy 4% preferred issued when rates were low trades far below par once market yields rise, and its market yield — not its 4% coupon — is what a new investor demands today.
F — flotation cost. The underwriting discount plus legal, accounting, printing and listing expenses attributable to the issue. Subtract it from the price to get net proceeds. The calculator accepts a percentage of price and a flat per-share amount, and adds them, because real deals often carry both.
Notice what is absent. There is no tax term, for the reason above. There is no growth term, because a fixed dividend does not grow. And there is no maturity, which is why the perpetuity form applies — an assumption that breaks for the two structures described further down.
Worked example: a $25 par 6.50% preferred trading at $22.00
A company has a Series A preferred with a $25.00 par value and a stated dividend rate of 6.50%. The shares trade at $22.00. The company is considering a new tranche on the same terms and expects underwriters to take 3.0% of the offer price. There are 4,000,000 shares outstanding.
- Find the annual dividend. $25.00 × 6.50% = $1.625 per share per year, paid as $0.40625 a quarter.
- Compute the market dividend yield. $1.625 ÷ $22.00 = 0.0738636, or 7.3864%. This is what an investor buying today earns, and it exceeds the 6.50% coupon precisely because the shares trade below par.
- Subtract flotation. $22.00 × 3.0% = $0.66, so net proceeds are $22.00 − $0.66 = $21.34.
- Divide the dividend by net proceeds. $1.625 ÷ $21.34 = 0.0761481, so the cost of preferred is 7.6148%.
- Read the flotation effect. 7.6148% − 7.3864% = 0.2284 percentage points. Issuance costs add roughly a quarter of a point to the rate the company pays.
- Value the obligation. $1.625 × 4,000,000 = $6,500,000 a year, and because the dividend is not deductible, the company must earn $6.5 million of after-tax profit to pay it. At a 21% marginal rate that requires $6,500,000 ÷ 0.79 = $8,227,848 of pre-tax income.
Now put the number in context. If the same company's debt yields 6.00% pre-tax, its after-tax cost of debt at 21% is 6.00% × 0.79 = 4.74%. The preferred costs 7.61% with no offsetting deduction — more than 2.8 points more expensive than debt that ranks ahead of it. The reasons to issue it anyway are structural rather than arithmetic: it carries no maturity and no covenant package, rating agencies and regulators often treat part of it as equity, and skipping a dividend is far less damaging than defaulting on interest.
How to read the result
Check the ordering first. Preferred ranks behind all debt and ahead of common stock, so its cost should normally fall between the two: above the company's pre-tax cost of debt and below its cost of common equity. If your figure sits below the pre-tax cost of debt, look for a stale price or a dividend entered quarterly. If it sits above the cost of common equity, the market is probably pricing a real risk that the dividend gets deferred, which is worth investigating before you use the number in a discount rate.
Read the gap between the market yield and the coupon as a statement about interest rates since issuance. Preferred trades like a long bond: because the dividend is fixed and perpetual, the price moves inversely with market yields and there is no maturity date to pull it back toward par. A share trading well below par is a legacy issue struck when yields were lower; one trading above par is the reverse, and it is also the case where a call becomes likely.
Be careful about whose cost you have computed. The market yield is the investor's required return. The cost measured on net proceeds is the issuer's cost of capital. They differ by the flotation effect, and only the second belongs in a WACC build-up for a company that is actually raising the money. For preferred already outstanding, leave the flotation fields at zero — the issuance cost is sunk, and loading it onto an existing tranche overstates the going-forward cost.
One tax subtlety runs the other way. Corporate holders of preferred can often exclude a large share of dividends received from taxable income under the dividends-received deduction, which is one reason preferred yields can look low relative to the risk. That benefit accrues to the buyer, not the issuer, and it changes nothing in this calculation.
Cost of preferred at common par values, coupons and prices
| Par | Stated rate | Annual dividend | Cost at 90% of par | Cost at par | Cost at 110% of par |
|---|---|---|---|---|---|
| $25.00 | 4.50% | $1.125 | 5.000% | 4.500% | 4.091% |
| $25.00 | 5.50% | $1.375 | 6.111% | 5.500% | 5.000% |
| $25.00 | 6.50% | $1.625 | 7.222% | 6.500% | 5.909% |
| $25.00 | 7.50% | $1.875 | 8.333% | 7.500% | 6.818% |
| $50.00 | 6.00% | $3.000 | 6.667% | 6.000% | 5.455% |
| $100.00 | 5.00% | $5.000 | 5.556% | 5.000% | 4.545% |
| $100.00 | 8.00% | $8.000 | 8.889% | 8.000% | 7.273% |
Because the dividend is fixed, the cost at 90% of par is always the stated rate divided by 0.90 and the cost at 110% is the stated rate divided by 1.10 — the par value itself drops out.
The perpetuity assumption breaks on callable and convertible issues
Most preferred stock issued today is callable, typically at par after five years. If the shares trade above par and a call is realistic, the true issuer cost is a yield to call, not a perpetuity yield: the company will redeem the issue at par and refinance, so the dividend stream is not perpetual. Treat this calculator's output as the upper bound on the term in that case.
Convertible preferred is a different instrument again. Part of what the holder is paid for is the conversion option, so the cash dividend understates the economic cost. Value the conversion feature separately rather than dividing the cash dividend by the price. Similarly, trust preferred and other hybrid structures can be classified as debt for tax purposes, in which case the payments are deductible and the no-tax rule above does not apply — check the instrument's tax characterisation before you decide.
Mistakes that put the cost of preferred wrong
- Entering a quarterly dividend as the annual figure. A $0.40625 quarterly payment is $1.625 a year. Using the quarterly number divides the answer by four.
- Applying a (1 − t) factor. Preferred dividends are not deductible to the issuer. Copying the debt treatment understates the cost by the full tax rate.
- Using par instead of market price. Par sets the dividend; the market price sets the yield. On a legacy low-coupon issue the two are far apart.
- Loading flotation costs onto existing shares. Issuance cost is sunk for preferred already outstanding. Use net proceeds only for a new issue.
- Treating a callable issue trading above par as a perpetuity. If a call is likely, yield to call is the honest measure and the perpetuity yield is an upper bound on the term.
- Ignoring arrears on cumulative preferred. Unpaid cumulative dividends must be caught up before common dividends resume, so the effective claim exceeds the current-year dividend.
- Netting the holder's dividends-received deduction against the issuer's cost. That benefit belongs to a corporate buyer and does not reduce what the issuer pays.
How preferred stock enters WACC, and when to bother
WACC carries a separate term for preferred whenever a material amount is outstanding: the cost of preferred weighted by preferred's share of total market-value capital, alongside the equity and after-tax debt terms. Use market value for the weight, as you would for equity and debt — book value of preferred can be far from market on a legacy issue. The WACC calculator takes preferred as its own component for exactly this reason.
Where preferred is a trivial fraction of capital, practitioners commonly fold it into debt or ignore it. That shortcut is defensible on a rounding basis and indefensible for banks, insurers, utilities and REITs, where preferred is often a deliberate and substantial slice of the structure because regulators or rating agencies give it partial equity credit. In those cases the misclassification distorts both the weights and the leverage you feed into a beta relevering step.
Preferred also complicates the equity ratios you compute alongside the discount rate. Return on common equity is measured after preferred dividends, and basic earnings per share subtracts them from net income before dividing by common shares, since they are not available to common shareholders. Whether preferred counts as debt or equity in a leverage ratio is a genuine judgement, and the answer differs between a rating agency, a lender's covenant definition and a debt-to-equity screen. State your treatment rather than leaving a reader to guess.
Key terms
- Par (stated) value
- The face amount a preferred share is issued against, commonly $25, $50 or $100. The dividend rate is quoted on par, and a call normally redeems at par.
- Cumulative preferred
- Preferred whose skipped dividends accrue as arrears and must be paid in full before any common dividend resumes.
- Flotation cost
- The underwriting discount plus legal, accounting and listing expenses of an issue. Subtracted from the offer price to give net proceeds.
- Net proceeds
- What the issuer actually receives per share after flotation costs. The correct denominator for an issuer's cost of capital on a new issue.
- Perpetuity
- A level payment stream with no end date. Its value is the payment divided by the required return, which inverts to give the cost of preferred.
- Yield to call
- The return assuming the issue is redeemed at the first call date and price rather than held forever. The right measure when a call is likely.
- Dividends-received deduction
- A U.S. provision letting a corporate shareholder exclude part of dividends received from taxable income. It benefits the holder, not the issuer.