312 Part 4 Investing in Long-Term Assets: Capital Budgeting
10-4 COST OF PREFERRED STOCK, r
p
The component cost of preferred stock used to calculate the weighted average
cost of capital, rp, is the preferred dividend, Dp, divided by the current price of the
preferred stock, Pp.10-3 Component cost of preferred stock! rp!
Dp
___P
p
Allied does not have any preferred stock outstanding, but the company plans to
issue some in the future and therefore has included it in its target capital structure.
Allied would sell this stock to a few large hedge funds, the stock would have a
$10.00 dividend per share, and it would be priced at $97.50 a share. Therefore,
Allied’s cost of preferred stock would be 10.3%:^10rp! $10.00/$97.50! 10.3%As we can see from Equation 10-3, calculating the cost of preferred stock is easy.
This is particularly true for traditional “plain vanilla” preferred that pays a! xed
dividend in perpetuity. However, in Chapter 9, we noted that some preferred issues
have a speci! ed maturity date and we described how to calculate the expected re-
turn on these issues. Also, preferred stock may include an option to convert to com-
mon stock, which adds another layer of complexity. We leave these more compli-
cated situations for advanced classes. Finally, note that no tax adjustments are made
when calculating rp because preferred dividends, unlike interest on debt, are not tax
deductible; so no tax savings are associated with preferred stock.Cost of Preferred
Stock, rp
The rate of return investors
require on the firm’s
preferred stock. rp is
calculated as the preferred
dividend, Dp , divided by
the current price, Pp.Cost of Preferred
Stock, rp
The rate of return investors
require on the firm’s
preferred stock. rp is
calculated as the preferred
dividend, Dp , divided by
the current price, Pp.SELF^ TEST Is a tax adjustment made to the cost of preferred stock? Why or why not?
A company’s preferred stock currently trades at $80 per share and pays a
$6 annual dividend per share. Ignoring # otation costs, what is the! rm’s cost
of preferred stock? (7.50%)10-5 THE COST OF RETAINED EARNINGS, r
s
The costs of debt and preferred stock are based on the returns that investors
require on these securities. Similarly, the cost of common equity is based on the
rate of return that investors require on the company’s common stock. Note, though,
that new common equity is raised in two ways: (1) by retaining some of the(^10) This preferred stock would be sold directly to a group of hedge funds, so no # otation costs would be incurred.
If signi$ cant # otation costs were involved, the cost of the preferred should be adjusted upward, as we explain in
a later section.
A company has outstanding 20-year non-callable bonds with a face value
of $1,000, an 11% annual coupon, and a market price of $1,294.54. If the
company was to issue new debt, what would be a reasonable estimate of
the interest rate on that debt? If the company’s tax rate is 40%, what is its
after-tax cost of debt? (8.0%; 4.8%)