Finding the cost of preferred stock is a really easy task. We're always going to use the equation below, and there aren't too many curveballs you can be thrown with this one.
In this equation, D is the dollar value of the dividend, and NP0 is the net price or in other words, the price minus any floatation costs. That's it! Let's check out a sample problem to see just how easy this is.
Sample Problem 1
JumboHost has recently issued preferred stock with a $5 dividend. The preferred stock has a $75 par value and sold for $72.25. Floatation costs on this issue were 3% of par. What is JumboHost's cost of preferred stock?
Soltion
This problem gives us $5 for the dollar value of the dividend. They tell us that the price is $72.25. Furthermore, floatation costs are 3% of par value, or $2.25. Your equation should now look like this:
Great! You got the correct answer of 7.14% with only a few minutes of studying! Try another one!
Sample Problem 2
GuitarCorp preferred stock has a par value of $50 and currently sells on the market for $56.00. The dividend rate is 7% and floatation costs on this issue amount to $4.00 per share. What is GuitarCorp's cost of preferred stock?
Solution
This one looks a little different, but we'll go through the same process. Remember that our equation needs a dollar value for a dividend but this problem is giving us something new called dividend rate. To get the dollar value, simply multiply the dividend rate times the par value. That gives you a dividend of $3.50 per share. Then in our equation, we have price minus floatation costs. These two numbers are both given to you in the problem!
You should have 6.73% as your answer. Easy! Just remember that when you're given a dividend rate, always multiply by the par value and not the market price! Try the practice problem below to make sure you've got the hang of this.
Practice Problem 1
Bats N' Balls Sporting Goods is looking to calculate their cost of preferred stock. The par value of their preferred stock is $25 and is currently selling for $23.80. The dividend rate is 8% and floatation costs amount to 3% of par. What is the cost of this preferred stock?
Solution
If you think the answer is 8.68%, then you've definitely got the hang of this!
Practice Problem 2
Scissor Snips Hair Salon, home of the 1-minute haircut, issued $100 par value preferred stock with a 16% dividend rate. The stock is currently selling at par, and the company paid $8 per share in floatation costs. What is the cost of their preferred stock?
Solution
A 1-minute haircut sounds a little risky. That really explains why their cost of preferred stock that you just got, 17.39% is higher than most.
That's really enough fun for now, folks. If you have any questions about this tutorial, or you'd just like to meet other finance students, check out the UnderstandFinance forums.