What it means
Preference shares are a hybrid instrument. Holders get a stated dividend, usually a fixed percentage of the par value, and they rank ahead of ordinary shareholders for both dividends and any payout if the company is wound up.
In exchange they normally give up voting rights and any share in the upside if the business does well. Because the dividend is fixed and expected to continue indefinitely, the maths is simpler than for ordinary equity.
You divide the annual dividend by the net amount raised per share, and that percentage is the cost. There is no growth rate to estimate and no beta to argue about, which is why this is the least contentious of the three components of the cost of capital.
The critical difference from debt is tax. Interest reduces taxable profit, but preference dividends are paid out of after-tax earnings, so a company gets no deduction for them.
That is why preference shares typically look more expensive than a loan at the same headline rate, and why they are usually issued when a business wants funding that does not add to reported gearing or trigger loan covenants. Companies also use preference shares when they want capital without diluting control, since holders generally do not vote.
Banks and insurers issue them to meet regulatory capital requirements, and family businesses sometimes use them to bring in outside money while keeping the ordinary shares, and therefore the decision-making, inside the family. The main variants matter for the calculation.
A cumulative preference share carries forward any missed dividend so it must be paid before ordinary shareholders get anything, while a non-cumulative one does not, and a callable share can be bought back by the company at a set price, which caps the holder's upside and slightly lowers the return they will accept.
In practice
Real-world examples.
Example
An insurer issues $50,000,000 of preference shares paying 6.5%, committing to $3,250,000 of annual dividends that cannot be deducted against tax. Its treasurer models the same amount as a 6.5% loan and finds the after-tax cost would have been only 4.875%, but accepts the difference because the preference shares count towards regulatory capital.
Example
A listed engineering group has legacy preference shares with a $25 par value paying 5%, so $1.25 a year, now trading at $20. New investors buying at that price earn 6.25%, which is the rate the company would have to match if it wanted to issue more.
Example
A private business brings in an outside investor through preference shares carrying an 8% cumulative dividend. Two lean years pass with no dividends paid, and the arrears accumulate, so when profits recover the founders cannot take anything until the backlog is cleared.
Think of it
“Cost of preferred is what you pay preferred shareholders for their investment-their required dividend yield.
Formula
Calculation
Cost of Preferred Stock = Annual preferred dividend per share / Net issue price per share. Suppose a company issues preference shares with a $100 par value paying a 6% dividend, so each share pays $6 a year, and the shares are placed with investors at $80 each. Cost of preferred stock = $6 / $80 = 7.5%. If issuing costs of $1.60 a share are deducted, the company only nets $78.40, so the true cost = $6 / $78.40 = 7.65%. Note there is no tax adjustment: unlike interest, that 7.65% is the full economic cost to the company.Case study
Seen in the real world.
Pelham Marine Group is an entirely fictional company used here for illustration. It needed $20,000,000 to buy two vessels but its bank facilities already carried a gearing covenant that a new loan would have breached. The board issued preference shares paying 7%, committing the group to $1,400,000 of annual dividends.
The finance director was careful to explain to the wider leadership team why this was not simply a 7% loan. With a 25% tax rate, borrowing at 7% would have cost 5.25% after tax, so the preference route was roughly a third more expensive in real terms, and that gap was the price of protecting the covenant and avoiding a dilutive share issue.
The illustrative lesson is that hybrid instruments are rarely cheap; they are a way of buying flexibility. Pelham built the dividend into its fixed cost base and reviewed the call option each year to see whether refinancing into ordinary bank debt had become sensible.
Watch out
Common mistakes.
- Applying a tax shield to preference dividends the way you would to interest, which understates the cost because those dividends are paid from after-tax profit.
- Using par value instead of the actual net proceeds per share, which gives the coupon rate rather than the real cost of the money raised.
- Assuming preference shares are risk-free for the company because dividends can be skipped, when cumulative arrears and reputational damage make skipping them costly.
Questions
People also ask.
Where does preferred stock sit in the capital structure?
Below all debt but above ordinary shares, so holders are paid after lenders and before ordinary shareholders in both dividends and liquidation.
Is the cost of preferred stock included in the weighted average cost of capital?
Yes, it forms a third component alongside debt and ordinary equity, weighted by its share of total capital at market values.
Why would a company choose preference shares over a loan?
Usually to avoid breaching debt covenants, to raise capital without giving away votes, or to meet regulatory capital rules, all of which can justify the higher cost.
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