8.5 : Cost of Preferred Stock

The cost of preferred stock usually falls between the cost of debt and the cost of equity. It tends to be higher than the cost of debt because dividends on preferred stock are not tax-deductible and carry a greater risk. However, it is lower than the cost of equity, as equity represents ownership with fluctuating dividends and voting privileges, which entail higher risks and potential returns.

Preferred stockholders usually get fixed dividends and no voting rights, making their investment less risky than common equity. Several factors influence the cost of preferred stock. Companies pay dividends on preferred stock using profits after taxes, unlike debt interest, which is tax-deductible. This makes the preferred stock a more expensive option for raising capital.

Preferred stock is attractive to investors when interest rates are low because it offers higher returns. When interest rates are high, its market value might drop as new securities with better yields appear. With regard to cumulative preferred stock, if dividends go unpaid in a given period, they accumulate and must be paid out before any dividends to common stockholders, affecting the investment's risk and return.

Understanding these factors helps assess the cost and appeal of preferred stock from both a company's and an investor's perspective.