Preferred stock, dividend rates

Predesign cost estimation, 5 Preferred stock, dividend rates on, 248-249 Preliminary designs, 14,16-18 example of 22-34,... 

New capital may also be obtained from the issue of bonds, preferred stock, or common stock. Interest on bonds and preferred-stock dividends must be paid at fixed rates. A relatively low interest rate is paid on bonds because the bond-holder has first claim on earnings, while higher rates are paid on preferred stock because the holder has a greater chance to lose the entire investment. The holder of common stock accepts all the risks involved in owning a business. The return on common stock, therefore, is not at a fixed rate but varies depending on the success of the company which issued the stock. To compensate for this greater risk, the return on common stock may be much higher than that on bonds or preferred stock. 

Interest on loans from banks, preferred stock and bonds is paid at a fixed rate of interest. A share of the profit of the company is paid as a dividend on common stock and preferred stock (in addition to the interest paid on preferred stock). 

If the annual income-tax rate for a company is 34 percent, every dollar spent for interest on loans or bonds would have a true cost after taxes of only 66 cents. Thus, after income taxes are taken into consideration, a bond issued at an annual interest rate of 6 percent would actually have an interest rate of only 6 X = 4.0 percent. On the other hand, the dividends on preferred stock must be paid from net profits after taxes. If preferred stock has an annual dividend rate of 7 percent, the equivalent rate before taxes would be 7 X = 10.6 percent. 

The cost of new capital obtained from bonds, loans, or preferred stock can be determined directly from the stated interest or dividend rate, adjusted for income taxes. However, the cost of new capital obtained from the issue of common stock is not so obvious, and some basis must be set for determining this cost. Probably the fairest basis is to consider the viewpoint of existing holders of common stock. If new common stock is issued, its percent return should be at least as much as that obtained from the old common stock otherwise, the existing stockholders would receive a lower return after the issue of the new stock. Therefore, from the viewpoint of the existing stockholders, the cost of new common stock is the present rate of common-stock earnings. 

The total investment required for a new chemical plant is estimated at 2 million. Fifty percent of the investment will be supplied from the company s own capital. Of the remaining investment, half will come from a loan at an effective interest rate of 8 percent and the other half will come from an issue of preferred stock paying dividends at a stated effective rate of 8 percent. The income-tax rate for the company is 30 percent of pre-tax earnings. Under these conditions, how many dollars per year does the company actually lose (i.e., after taxes) by issuing preferred stock at 8 percent dividends instead of bonds at an effective interest rate of 6 percent ... 

A share buyback can be an advantage for bondholders, if a low stock price is lifted, thus reducing the danger of a takeover and a change of management. A stock buyback lowers future dividend payments. This may be advantageous for bondholders if there are, for example, high dividends on preferred stock which are de facto paid independently of the economic situation and thereby have the character of a fixed interest rate. Sometimes a share buyback can turn out to be more pleasant than invest-... 

The cost of capital is what it costs a company to borrow money from all sources, such as loans, bonds, and preferred and common stock. It is an important consideration in determining a company s minimum acceptable rate of return on an investment. A company must make more than the cost of capital to pay its debts and make a profit. From profits, a company pays dividends to the stockholders. If a company ignores the cost of capital to increase dividends to the stockholders, then management is not meeting its obligations to pay off outstanding debts. 

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