A fundamental lesson for any first-year business student is how to calculate the cost of debt. Specifically, how to calculate the weighted average (debt and equity) cost of capital in order to value a particular company's stock price. One consideration in the weighted average cost of capital equation is the after tax cost of preferred stock. The most important thing to know when calculating the after tax cost of preferred stock is that, unlike interest payments (which is an expense), dividends are paid out with after-tax income.
Understand what preferred stock is. Preferred stock has characteristics of both debt and equity securities. It requires a regular payment to shareholders, but does not require repayment of the principal. Under the prevailing tax laws of 2009, these interest payments are treated as dividends.
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Understand the difference between debt and preferred stock. Due to the tax consideration, the only difference between preferred stock and debt is the tax consideration given to debt. Interest paid on bonds or loans is considered a deductible expense for the company--a tax break that is not given to preferred stock payouts, which are considered dividends, or the partial distribution of income to the shareholders. From the company's perspective, the cost of debt on preferred stock equals the dividend divided by the net proceeds from the stock sale. There is no adjustment for a tax break because there isn't any.
Work through an example. Say the transactions costs associated with selling a $1,000 share of preferred stock is $25.The dividend on each preferred share is $110.
Calculate the proceeds from the sale and then divide it into the dividend per share for the after-tax cost of preferred stock. $110 / $975= 11.3 percent. This is the after-tax cost of preferred stock to the company. In effect, it means that the company will pay 11.3 percent per year for the privilege of using the shareholder's net $975 investment.