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source: Diana Shipping
Cost of Preferred Stock | Advantages | Formula | Example – Preferred stock allow an investor own a stake at the issuing company with a condition that whenever company decides to pay dividends , the holders of this stock will be first to be paid.
In this article, we discuss preferred stocks in depth, how the cost of preferred stocks is calculated, its formula with examples –
- Preferred Stock vs Common Stock
- Types of preferred stock
- Advantages of preferred stock – Company’s point of view
- Advantages of preferred stock – Investors point of view
- Disadvantages of preferred stock – Company’s Point of view
- Disadvantages of preferred stock – Investors Point of view
- Cost of Preferred stock
Preferred Stock vs Common Stock
Capital stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which take precedence over common stock in the event of liquidation. This stock is type of class of corporate share in which the common shareholders have not avail any specific rights. This stock come with a special right that provide the investors preferential status over the common shareholders.
Preferred stockholders usually have the right to receive dividend before common stockholders, which means that the preferred stockholders will be paid dividend on first priority and then onwards any dividends remaining will go over to common stockholders. This stock is also commonly known as preference share.
Preferred stock is also stated as quasi debt tool as they are the combination of the characteristics of debt and equity both. On one hand to receive dividend at fixed rate, they carry preferential right over the ordinary shares whereas in other hand they take on the unsecured equity risk, except to preferential right on behalf of repayment in occurrence of winding up of the company or organisation.
Types of preferred stock
Other than common stock, there are a variety of features or characteristics that can be additional to preferred stock in position to either enhance its position and attractiveness to investors, or to make it easier and simpler for the issuing company to buy back of stock or shares. In order to achieve the goal of the company and to meet the needs of investors we may elect to use just one of the following features or characteristics, or several at once provided below:
#1 – Cumulative preferred stock
Cumulative stock or shares where undeclared dividends permitted to accumulate still they are paid which means it has a right to a particular amounts of dividend every year. If the dividend are not able paid or declared, the stock can accumulate the dividends unpaid for a future period in which they are declared
source: Hanesbrands Inc
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#2 – Non-cumulative preferred stock
Where as in case of non-cumulative stock, if the dividend are not available to declared in current period than the preferred stock face the situation to lose any kind of dividend. The non-cumulative stock do not accumulate any kind of unpaid dividend. It does not utilize the dividend in arrears account for unpaid dividends.
#3 – Redeemable preferred stock
Redeemable stock ca be redeemed on or after a period fixed for redemption under the terms and conditions of issue or after giving a proper notice for the redemption to preference stockholders. The companies act, however, imposes certain restriction for the redemption of preference stock.
#4 – Irredeemable preferred stock
Irredeemable stock are those types of stock or shares which cannot be redeemed during the lifetime or period of the company.
#5 – Convertible Preferred stock
In case of convertible stock, the convertible character provides a company to transfigure their preferred stock into a pre-decided numbers of shares of common stock of the organisation or company at some point in future. The conversion features or characteristics is at first set a transmutation rate that is not fascinating in the eyes of investors at the time of purchase or buy. However, if the cost of the ordinary stock hike, then the investors can transform to ordinary stock, and may then the stock will dispose to realize an instant profit.
We can see the details of convertible preferred stock through the following illustration, if an ABC LTD. paid $ 500 for a share of preferred stock that converts to five stock of the common stock of the company. The common stock initials sells for $ 100 per stock, so ABC Ltd. Would earn no gain by conference. However, afterwards it has been increases to $ 175 per stock, so ABC Ltd. would be willing to convert to ordinary stock and sold his five shares of common stock for a total of $ 875, thereby receiving a profit of $ 375 per stock of preferred stock purchased. This is considered a valuable characteristics if there is an expectation that the amount of the organisation will enhance during time period.
#6 – Non-convertible Preferred stock
In case of non-convertible stock the holders of non-convertible preferred stock have no such right of conversion.
#7 – Participating Preferred stock
The holders of participating preferred stock have a right to participate in the surplus or additional profits of the company remained after paying dividend to the ordinary shareholders and preference shareholders at a fixed rate.
#8 – Non-participating preferred stock
Whereas in case of non-participating stock, the preference stock do not have such right to participate in surplus or additional profits.
Advantages of preferred stock – Company’s point of view
- The dividend payable on this stock is fixed which is usually lower as compared to payable on equity shares. As a results they facilitates the company to enhancing the profits convenient for the dividend available to equity shareholders.
- Preferred shareholders have no voting right on matters that not effecting their right from now promoters or management can keep command over the circumstances of the corporate.
- The corporate or the organisation should continue limberness in its capital structure through issuing of redeemable preference stock or shares as they will be redeemed under the conditions of issue.
- Issue of preferred stock does not prove or state a burden on finance of the company because the reason behind this is, the dividends are paid only if the sufficient amount of financial surplus available or on dividends are to be paid.
- Non-availability of payment of dividend on preference stock does not generate a charge on the company’s assets.
- The issue of this stock spread the range of capital market as they provide the security not only to the investors but also to fixed return. If the company is not able to issue preferred stock which means it will insufficient to create the attraction for the capital from such ordinary types of investors.
Advantages of preferred stock – Investors point of view
- Investors in cumulative preferred stock get a fixed rate of dividend on this stock uniformly even if there is none availability of profit. If there is any arrears regarding dividends is available will be paid in the years of profit.
- Preferred stock carry preference right as regard to the payment of dividend and preferential right as evaluate to paying back of capital in happening of the company’s winding up, as a consequence they enjoy lower rate of risk.
- Preference stockholders are provided voting rights in the occurrence that directly affecting their interest, which clearly stated that interest is their protection.
- As the preference stockholders take delights that the preferential rights of their capital’s repayment in case of winding up of the company, it provides them protection from capital loses.
- Preferred stock are stated as fair securities for the shareholders during the recession periods when the profits of the company are down.
Disadvantages of preferred stock – Company’s Point of view
- Company is to pay the dividends at higher rate on these stock than the existing rate of interest on the debentures. As a result it’s generally enhances the cost of the capital of the company.
- Generally most of the preferred stock are issued cumulative which means that all the arrears of dividend must be paid on first priority before any can be paid to equity stockholders. It is the responsibility of the company to pay dividend on such kind of shares. Which result in reduction of the profits of the equity shareholders.
- The issue of preferred stock inculpate reduction of equity shareholders affirm over the assets of the company because there is a preferential right available to preference stockholders over the assets of the company in winding up case.
- The debt freeness of the company is extremely influence by the issue of preferred stock. The creditors may anticipated that that the continuity of dividend on stock and adjournment of dividend on equity capital may divest them with regarding to chance of get back their sum amount in full in the happening of cessation of the company, as the preferred capital has the preference right on the assets of the company.
- The amount of preference dividend does not affect any reduction on taxable income.
Disadvantages of preferred stock – Investors Point of view
- There is not availability of any voting rights to preference stockholders except in matters directed to affect their interest.
- The dividend on preferred stock other than the participating preferred stock is fixed even if the company is earning higher profits.
- The preference shareholders have no claim over the surplus amount or figure. They can only ask for the return of their capital amount invested in the company.
- Company does not provides any safeguard to the preference capital as is made in case of debentures. Which results non protection of their interest by the assets of the company.
Cost of Preferred stock
The cost of preference share capital is the rate of return that must be earned on preference capital financed investments, to keep unchanged the earnings available to the equity shareholders. In other words, cost of preferred stock is the rate of return required by the holders of a company’s preferred stock.
Cost of Irredeemable preferred stock
The cost of irredeemable preferred share capital is the rate of preference dividend, also called the coupon rate divided by net issue proceeds. In case of Irredeemable preferred stock, the cost of irredeemable preferred stock is calculated as :
Cost of Preferred Stock Formula
Kp i.e. cost of preferred stock = Annual dividend of Preferred stock/Net proceeds received from the issue of preferred stock after meeting the issue expenses or Market price of the preferred stock.
Cost of Irredeemable preferred stock Example 1
XYZ limited has issued 10,000 irredeemable preference share with face value of $ 100 each. The cost of preference share capital is 10 %. The market price of share is currently $ 115. Calculate the cost of preferred share capital.
Annual dividend = $ (100 * 10/100) = $ 10
Kp = $ 10/$ 115 = 8.7 %
Cost of Irredeemable preferred stock Example 2
ABC limited has issued 10,000 irredeemable preference shares of $ 150 each at a coupon rate of 14 % per annum. The flotation cost are $ 15 per share. Calculate cost of preferred share capital.
Cost of Preferred Stock or Kp = 14 % of $ 150/ ($ 150 – $ 15) = $ 21/$ 135 = 0.1555 = 15.55 %
Cost of redeemable preferred stock
The cost of redeemable preferred stock or redeemable preference capital having fixed maturity date is calculated as follows :
Cost of Preferred Stock Formula
Kp i.e. cost of redeemable preferred stock or shares = [Annual dividend + (Redeemable value – sale value)/number of years of redemption]/ [(Redeemable value of preferred stock or shares + sale value of shares)/2]
Cost of redeemable preferred stock Example
D limited has $ 100 preference share redeemable at a premium of 10 % with 15 years maturity. The coupon rate is 12 %. The flotation cost is 5 %. Sale price is $ 95. Calculate the cost of preferred stock or preference shares.
Redeemable value = $100+ $ 10 = $ 110
Sale value = $ 95 – $ 5 = $ 90
Annual dividend = $ 100 * 12/100 = $ 12
Kp = [12+ (110 -90)/15] / [(110 + 90)/2) = 12 + (20/15) / 200/2 = (12 + 1.33)/100 = 0.133
= 13 % (Appx)