Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy(^528) 15. Cost of Capital © The McGraw−Hill
Companies, 2002
The Cost of Preferred Stock
Determining the cost of preferred stockis quite straightforward. As we discussed in
Chapters 6 and 8, preferred stock has a fixed dividend paid every period forever, so a
share of preferred stock is essentially a perpetuity. The cost of preferred stock, RP, is thus:
RPD/P 0 [15.3]
where Dis the fixed dividend and P 0 is the current price per share of the preferred stock.
Notice that the cost of preferred stock is simply equal to the dividend yield on the pre-
ferred stock. Alternatively, because preferred stocks are rated in much the same way as
bonds, the cost of preferred stock can be estimated by observing the required returns on
other, similarly rated shares of preferred stock.
CONCEPT QUESTIONS
15.3a How can the cost of debt be calculated?
15.3bHow can the cost of preferred stock be calculated?
15.3c Why is the coupon rate a bad estimate of a firm’s cost of debt?
500 PART SIX Cost of Capital and Long-Term Financial Policy
The Cost of Debt
Suppose the General Tool Company issued a 30-year, 7 percent bond 8 years ago. The bond
is currently selling for 96 percent of its face value, or $960. What is General Tool’s cost
of debt?
Going back to Chapter 7, we need to calculate the yield to maturity on this bond. Because
the bond is selling at a discount, the yield is apparently greater than 7 percent, but not much
greater because the discount is fairly small. You can check to see that the yield to maturity is
about 7.37 percent, assuming annual coupons. General Tool’s cost of debt,RD, is thus 7.37
percent.
EXAMPLE 15.2
Alabama Power Co.’s Cost of Preferred Stock
On September 4, 2001, Alabama Power Co. had two issues of ordinary preferred stock that
traded on the NYSE. One issue paid $1.30 annually per share and sold for $21.25 per share.
The other paid $1.46 per share annually and sold for $23.05 per share. What is Alabama
Power’s cost of preferred stock?
Using the first issue, we calculate that the cost of preferred stock is:
RPD/P 0
$1.30/21.25
6.12%
Using the second issue, we calculate that the cost is:
RPD/P 0
$1.46/23.05
6.33%
So, Alabama Power’s cost of preferred stock appears to be in the 6.1 to 6.3 percent range.
EXAMPLE 15.3