Foundations of Financial Management: An Analysis (part 40)

“You must gain control over your money or the lack of it will forever control you.” 

– Dave Ramsey

Cost of Capital (Part B)

by

Charles Lamson

Costs of Preferred Stock

The cost of preferred stock is similar to the cost of debt in that a constant annual payment is made, but dissimilar in that there is no maturity date on which a principal payment must be made. Determining the yield on preferred stock is simpler than determining the yield on debt. All you have to do is divide the annual dividend by the current price (this process was discussed in parts 35 and 38 of this analysis). This represents the rate of return to preferred stockholders as well as the annual cost to the corporation for the preferred stock issue.

We need to make one slight alteration to this process by dividing the dividend payment by the net price or proceeds received by the firm. Since a new share of preferred stock has a selling cost (flotation cost), the proceeds to the firm are equal to the selling price in the market minus the flotation cost. The cost of preferred stock is presented as Formula 3.

In the case of the Lamson Corporation, we shall assume the annual dividend is $10.50, the preferred stock price is $100, and the flotation, or selling cost is $4. The effective cost is:

Because the preferred stock dividend is not a tax-deductible expense, there is no downward tax adjustment.

Please refer back to Table 1 from last post and observe in column (1) that 10.94 percent is the value we used for the cost of preferred stock.

Cost of Common Equity

Determining the cost of common stock in the capital structure is a more involved task.

Valuation Approach

In determining the cost of common stock, the firm must be sensitive to the pricing and performance demands of current and future stockholders. An appropriate approach is to develop a model for valuing common stock and to extract from this model a formula for the required return on common stock.

In part 36 of this analysis we discussed the constant dividend valuation model and said the current price of common stock could be stated to equal:

This means stockholders expect to receive a 5 percent dividend yield on the stock price plus a 7 percent growth in their investment, making a total return of 12 percent.

Alternate Calculation of the Required Return on Common Stock

The required return on common stock can also be calculated by an alternate approach called the capital asset pricing model. This topic is covered in the next post, so only brief mention will be made at this point. Some accept the capital asset pricing model as an important approach to common stock valuation, while others suggest it is not a valid description of how the real world operates.

Under the capital asset pricing model (CAPM), the required return for common stock or other investments can be described by the following formula:

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 316-318*

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