Cost of Preferred Stock
Preferred stock shares some of the characteristics of
debt—thepreferreddividendisprespecifiedatthetimeofthe
issueandispaidoutbeforecommondividend—andsomeof
the characteristics of equity—the payments of preferred
dividend—arenottaxdeductible.Ifpreferredstockisviewed
as perpetual,thecost of preferred stock canbe written as
follows:
Thisapproachassumesthatthedividendisconstantindollar
terms forever and that the preferred stock has no special
features (convertibility, callability etc.). If such special
featuresexist,theywillhavetobevaluedseparatelytocome
up witha good estimateof thecost ofpreferred stock. In
termsofrisk,preferredstockissaferthancommonequitybut
riskierthandebt.Consequently,itshould,onapretaxbasis,
command a higher cost than debt and a lower cost than
equity.
Cost of Other Hybrid Securities
In general terms, hybrid securities share some of the
characteristics of debt and some of the characteristics of
equity.Agoodexampleisaconvertiblebond,whichcanbe
viewed as a combination of a straight bond (debt) and a
conversionoption(equity).Insteadoftryingtocalculatethe
cost of these hybrid securities individually, they can be
broken down into their debt and equity components and
treatedseparately.Ingeneral,itisnotdifficulttodecompose