632598256894

The dividend per share for preferred stock is fixed through time, and, if the firm is liquidated, the
preferred stockholders will receive par value at the most. These characteristics more closely describe
debt securities or bonds, so preferred stock is often considered to be more like debt, but preferred
stock differs from true debt because it has no maturity date; it has an infinite life and will pay its fixed
dividend forever. Any asset or security that pays a fixed cash amount forever is called a perpetuity,
and preferred stock with its infinite and fixed dividend fits this description precisely. The required
return or cost of capital for preferred stock can therefore be calculated with the formula for a
perpetuity, which is:
So the cost of preferred stock is equal to the dividend yield at the current market price. If a share of
preferred stock has a $3 dividend and a current market price of $40, then investors are willing to
purchase the preferred stock at a return of $3 ÷ $40, which equals 0.075 or 7.5%; this is the required
return and cost of capital for this share of preferred stock.
If a company has preferred stock outstanding, the cost of preferred stock as just calculated must be
included when calculating the firm‟s cost of capital. For the majority of companies this is not
necessary, as preferred stock is rarely observed in the capital structure of firms in the year 2008.
Preferred stock has primarily been used in recent years as part of the early stage financing of start-up
companies, where investors have received preferred stock convertible into shares of common stock,
which they will convert into common stock if the company succeeds. If the company performs well
and becomes a publicly owned company, or it is purchased by another firm, this preferred stock is
converted into common stock and retired. If the company performs poorly and fails, the preferred
stock disappears. Be aware, however, that preferred stock does exist in the capital structure of some
companies, so be sure to look for it when examining the firm‟s balance sheet. If a company does have
preferred stock outstanding, be sure to calculate the cost of this preferred stock and include it in the
overall cost of capital for the firm.
Weight of Debt and Equity Capital
We have examined how to calculate a company‟s cost of debt and cost of common and preferred
equity, but to determine its weighted average cost of capital we also need to know the relative
proportions or weights of debt and common and preferred equity in its capital structure. The weight of
debt in the capital structure is calculated as:
This ratio is called the long-term debt to capitalization ratio, as the denominator is the total longterm
capital of the firm, and the numerator is the firm‟s long-term debt. The weight of common equity
in the firm‟s capital structure is calculated with the same formula, except common equity is the
numerator: