Noncallable, Nonconvertible Preferred Stock

A preferred stock that does not give its holder the right to convert their preferred shares into a fixed number of common shares, usually after a predetermined date, is called a nonconvertible preferred stock. A noncallable, nonconvertible preferred stock is a nonconvertible preferred stock that does not give the issuer the right to call in or redeem the preferred stock at a preset price after a predetermined date.

Cost of Noncallable, Nonconvertible Preferred Stock

$$ { P }_{ p }=\frac { { D }_{ p } }{ { r }_{ p } } $$

Where:

P_p = the current price per share of the preferred stock

D_p = the preferred stock’s dividend per share

r_p = the cost of the preferred stock

Rearranging the equation to make r_p the subject, the cost of preferred stock is:

$$ r_{ p }=\frac { { D }_{ p } }{ { P }_{ p } } $$

In other words, if we know how much dividend a preferred stock pays as well as the current price of the preferred stock, we can obtain the cost of the preferred stock by simply dividing the preferred stock’s dividend per share by its current price per share.

Remember that the dividend paid on preferred stock is not tax-deductible. Therefore, there is no need to make any adjustment for taxes.

Question

Company D issues fixed-rate, noncallable, nonconvertible preferred stock priced at $102 and paying dividends of $7.24. Company D’s marginal tax rate is 35%. What is the estimate of company D’s cost of preferred stock?

A. 4.61%

B. 7.10%

C. 7.24%

Solution

The correct answer is B.

Using the formula:

$$ r_{ p }=\frac { { D }_{ p } }{ { P }_{ p } } $$

The cost of preferred stock = $7.24/$102 = 7.10%.

Reading 33 LOS 33g:

Calculate and interpret the cost of noncallable, nonconvertible preferred stock