The Cost of Preferred Stock

Determining the cost of preferred stock is 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:

where D is the fixed dividend and P0 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 preferred 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.

EXAMPLE 15.3 |

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:

Using the second issue, we calculate that the cost is:

So, Alabama Power's cost of preferred stock appears to be in the 6.1 to 6.3 percent range.

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