How is the cost of preferred stock determined?

The determination of the cost of preferred stock involves calculating the required rate of return for investors who hold that stock. This is primarily done by examining the dividends that investors expect to receive relative to the price they pay for the stock.

To compute the cost of preferred stock, the formula used is the annual dividend divided by the net issuing price (the price investors actually pay for the stock after considering any floatation costs). This ratio gives a clear measure of the yield that investors can expect based on their investment, effectively capturing the essence of their return on investment.

Such a calculation is important because it helps companies understand how much it will cost them to raise funds through preferred stock issuance. Investors, on the other hand, use this rate to assess whether the investment meets their required return based on the associated risks.

This method emphasizes the primary role of dividends in determining returns from preferred stock, making it essential for financial decision-making in both company strategy and investor evaluations.