Cost of Preferred Stock

Builds onPresent Value of a Perpetuity — if this page feels steep, start there.

r_p = \frac{D_p}{P_p}

$D_p$: the fixed annual preferred dividend, set when the shares are issued
$P_p$: the current market price of a preferred share
$r_p$: the required return (and issuer's cost): the flat yield the market demands forever

Why it must be true

Preferred stock is a perpetuity wearing a suit: it promises the same fixed dividend forever, with no maturity and no growth. The perpetuity formula says a forever-payment of $D_p$ is worth $D_p / r$ — so if the market pays price $P_p$ for it, the market is telling you the rate it demands. Just solve backwards: $r_p = D_p / P_p$ .

That is the cost of preferred from the issuer's side: the yield investors require to hold a flat, never-ending dividend. No tax adjustment applies — unlike interest, preferred dividends are paid from after-tax profits.

The derivation

Start from the perpetuity valuation you already know:

P_p = \frac{D_p}{r_p}

The market sets $P_p$ ; the charter sets $D_p$ . The only unknown is the rate, so rearrange:

r_p = \frac{D_p}{P_p}

The cost of a security, viewed from the issuer, is always the investor's required return read off the market price — this is the cleanest example of that principle in the whole WACC.

When to reach for it

Finding the preferred-stock component of a WACC, or the yield on any flat perpetual dividend given its market price.

Listen for

“cost of preferred stock”“fixed preferred dividend of … per share”“preferred shares trade at …”“perpetual dividend”

Back-of-the-envelope

Estimate it in your head first — then the calculator only confirms.

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Par-anchored issues make it instant: an '8% preferred on $100 par' trading AT par costs exactly 8%; below par costs more, above par less.
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Same mental move as a bond's current yield: annual payment over price. If $6 on $75, think 6/75 = 8%.

Traps in applying it

✗Applying the (1 − t) tax shield — preferred dividends are NOT tax-deductible to the issuer; no haircut.
✗Using par value instead of the market price in the denominator — the cost is set by today's market, not the original issue terms.
✗Adding a growth term — straight preferred has none; g belongs to common equity's DDM.

Limits & criticisms

The clean perpetuity story bends for real-world features: callable preferreds (the issuer can redeem, capping upside), floating-rate and convertible variants, and cumulative/non-cumulative dividend terms all move the true cost away from D/P. Thinly traded preferred prices can also be stale, making the "market-implied" rate less market-like than it looks.

Where it came from

Preferred stock boomed in 19th-century railroad finance — investors wanted bond-like income with equity's upside hopes — and its valuation-as-perpetuity is as old as the instrument. Today the formula prices the preferred sleeve of bank capital stacks (where regulators love perpetual instruments), utilities' financing, and Berkshire Hathaway's famous crisis-era preferred deals; in every WACC with preferred in the structure, this ratio is the component cost.

One identity, 2 questions

The exam can hide any variable. Each face below is the same equation solved for a different unknown — drill them separately.

Market-implied cost

r_p = \frac{D_p}{P_p}

The WACC-input face: the market price reveals the rate investors demand for a flat forever-dividend.

Drill this face →

Preferred share value

P_p = \frac{D_p}{r_p}

The perpetuity face, unrearranged: given a required return, the fair price of the flat dividend stream.

Drill this face →

On the BA II Plus

Worked example: Preferred shares paying $8.00 annually currently change hands at $70.00. What component cost should the WACC use for preferred?

1.8 [÷] 70 [=]dividend over price (decimal)

→ 11.43%

Drill this formula Back to the library