Preferred Stock: Fish or Fowl?

In my last post, I talked about hybrids but I stuck with the conventional example of convertible debt. In this one, I would like to draw attention to another source of financing - preferred stock - which I find much more difficult to work with.

Before I begin, though, let me also draw a distinction between preferred stock in the United States and preferred stock in some other parts of the world (such as Brazil). In the United States, preferred stock commands a fixed dollar dividend that is set at the time of the issuance. If you buy preferred stock, your returns come primarily from the dividends - any price appreciation (or depreciation) is a side story. In much of Latin America, preferred stock is really common stock with preferential claims on dividends and limited voting rights. The dividends are usually specified as a percentage of earnings (rather than as an absolute number) and will go up, if the company is doing well, and go down, if not. Returns therefore mirror returns on common stock, with dividends and price appreciation.

Where should we put preferred stock in the cost of capital computation?
1. With the "common stock" variety preferred, the answer is easy. Treat it as equity, even though it may be called preferred stock.
2. With the "fixed dividend" preferred stock, our task becomes more difficult. It is clearly not equity, notwithstanding what it is called, since your claim is on a fixed dividend. (If you have preferred stock that is entitled to more cash flows, such as a share of the remaining profits, I would consider it equity). Including this item in debt creates a problem, since preferred dividends are not tax deductible (and attaching an after-tax cost of debt to the overall debt will understate the cost of preferred).

Here is my compromise solution. If the value of preferred stock is less than 5% of overall firm value (market), act like it does not exist for cost of capital purposes and subtract the preferred dividend out from earnings and cash flows. (It will make little difference to your cost of capital, if you do include it, and more headaches than it is worth) If it is more than 5%, we have no choice but to create a third source of capital and give it it's own cost. The cost of preferred stock should be the preferred dividend yield (which will be lower than the cost of equity but higher than the pre-tax cost of debt).
Preferred dividend yield = Preferred dividend per share/ Preferred stock price

The puzzle then becomes the following. Preferred stock is essentially very expensive debt (because you do not get the tax advantage). So, why would any sensible firm even use it to raise capital? More on that in my next post.