Finding the specific after-tax cost of common stock (rp)

Our next concern is to find the after-tax cost of common stock, after attending to finding the after-tax cost of long-term debt and after-tax cost of preferred stock.

Common stock


Common stock, which is also called common shares or ordinary shares, refers to the category of ownership of the enterprise. Common shares generally have voting rights and better potential for appreciation of shares compared to preferred stock.

However, holders of common stock generally do not have fixed dividends and cannot receive dividends until dividends are paid out to preferred stock holders. Moreover, in case of liquidation, holders of common stock only have claim on company’s assets if claims of all creditors as well as holders of preferred stock are satisfied. Therefore, common stock is more risky than preferred stock.

Cost of common stock (rp)

To determine the specific after-tax costs of common stock (rp), you can use two techniques: Gordon model or the CAPM (Capital Asset Pricing Model)

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Finding the after-tax cost of preferred stock (rp)

After discussing the cost of long-term debt, we must now find the cost of preferred stock (after-tax). Preferred stock, which is also called preferred shares or preference shares, refers to the category of ownership that has preferential claim on earnings and assets of the firm, compared to common stock ownership.

The preferential claim is generally manifested in the fact that dividends cannot be distributed to common stockholders until it is distributed to holders of preferred stock first. Further, in case of liquidation, holders of the preferred stock also have preferential claim on assets of the firm, compared to the holders of common stock.

Preferred stock is a hybrid instrument as it has characteristics of both debt and equity. The drawback of preferred shares, compared to the common stock, is lower potential for appreciation of shares as well as absence of voting rights.

Calculating the cost of preferred stock


To calculate the specific after-tax cost-of-preferred-stock all we need to do is to take the preferred stock dividend and divide it by the net proceeds from the sale of the preferred stock (funds received minus flotation cost).

Cost-of-preferred-stock (rp) = Preferred stock dividend/(Funds received – Flotation costs)

Because preferred stock is paid out of the after-tax earnings, the cost-of-preferred-stock is already after-tax.

EXAMPLE:

If Company A issued 9% preferred stock at $100 and the flotation cost is $8, then the calculation will be as follows:

rp = 100*9%/100-8

rp =9/92

rp =9.8%

Test yourself


A corporation is issuing 10% preferred stock that should be sold for $15 each. The business will incur flotation costs of $2 per share.

REQUIRED: What is the cost-of-preferred-stock?

SOLUTION:

10%*15/15-2

1.5/13

The answer is 11.54%

Note: If you struggle with a calculation, read using a financial calculator article for some simple tips on using a financial calculator.

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Sign up to receive a 3-part FREE strategy video training series here.