Preferred stock is a type of equity that business firms can use to finance their operations. If a firm uses preferred stock, then its cost must be included in the company's weighted average cost of capital calculation.
Characteristics of Preferred Stock
Like common stock, preferred stock dividends are not tax-deductible. The only component in the cost of capital calculation that pays tax-deductible income is debt. Preferred stockholders do not have to be paid dividends, but the firm usually pays them. If they don't, they can't pay dividends to their common shareholders and it is a bad financial signal for the firm to send out.
Calculation of the Cost of Preferred Stock
If preferred stock has no stated maturity date, here is the formula for calculating the component cost of preferred stock:
Cost of Preferred Stock = Dividend on Preferred/Price of Preferred/1-Flotation Costs
where Price of the Preferred is the current market value and the flotation costs are the underwriting costs for the issuance of the preferred stock stated as a percentage.
Usually, the cost of preferred stock will be higher than the cost of debt as debt is seen as the least risky component cost of capital.
If a firm uses preferred stock as a source of financing, then it should include the cost of the preferred stock in the weighted average cost of capital formula.
Most preferred stock is held by other companies instead of individuals. If a company holds the preferred stock, it is allow to exclude 70% of the dividends from the preferred from taxation, so this actually increases the after-tax return.