Companies are always striving to reduce their cost of capital -- the price of accepting money from creditors and shareholders. As a general rule, debt is less costly than equity because creditors are paid before shareholders. Among the types of equity, preferred stock is less costly than common stock and can therefore be issued to reduce a company's cost of capital.
Weighted Average Cost of Capital
One of the fundamental concepts of corporate finance is the weighted average cost of capital, or WACC. It expresses the blended cost of all sources of capital utilized by a company. Generally speaking, the cost of capital increases as companies tap riskier sources of funds. At the top of the hierarchy sit the creditors, who receive their interest and principal payments before anyone else. Next are the preferred shareholders, who receive their dividends before those promised to common shareholders, who sit at the bottom of the capital structure.
How to Calculate WACC
To calculate WACC, figure out the proportion of each source of capital and multiply it by its cost. Suppose that a company is funded by $15 million of capital broken down into $10 million of debt, $3 million of preferred equity and $2 million of common equity. Assume that the debt carries an interest rate of 5 percent, preferred equity costs 7 percent and the common equity 10 percent. In this case, the company's WACC is 6.1 percent: (10/15 * 5%) + (3/15 * 7%) + (2/15 * 10%).
Preferred Stock and Its Characteristics
Preferred stock is a form of equity that receives its dividends before common stockholders. In exchange for its seniority, it gives up the right to share in the company's earnings. For example, if a company issues preferred stock with a $5 dollar quarterly dividend, that is all that the preferred shareholders will ever receive, even if the company reports quarterly earnings of $100 per share. Preferred stock may be cumulative, meaning that any missed dividend payments must be made up in the future before paying common shareholders, or noncumulative. In some cases, it also may be convertible into common shares under certain guidelines.
Using Preferred Stock to Reduce WACC
Preferred stock can be used to reduce a company's WACC by substituting more expensive common equity with less expensive preferred equity. In some cases, preferred equity might even be less expensive than certain forms of unsecured debt. To calculate the cost of preferred stock, divide its dividend by its share price. For example, if a company's preferred stock is trading at $80 with a quarterly dividend of $1, its cost of capital per year is 5 percent, or $4 divided by $80. If the cost of common equity is higher than 5 percent, the company has an opportunity to reduce its WACC by buying back common shares and replacing them with preferred shares.