Charta is on Google Play: practise on the go. Get the app
Charta

Work out the cost of both common and preferred equity

CFA® Level I · Corporate Issuers · Capital Structure · CI.3.c

The idea

Preferred equity pays a fixed dividend with no maturity, so its cost is the dividend divided by the current price — a perpetuity calculation. Common equity has no contractual payment, so its cost must be inferred. The capital asset pricing model estimates it as the risk-free rate plus beta times the equity risk premium. The dividend discount approach rearranges the Gordon growth model to give the expected dividend yield plus the growth rate. Unlike interest, neither kind of dividend is tax-deductible, and both rank behind debt, which is why equity is the more expensive source and debt the cheaper one.

Formulas

Cost of preferred stock

rp = Dp ÷ Pp

Dp
the fixed preferred dividend per share
Pp
the current market price of the preferred share

A perpetuity, because the dividend is fixed and has no end date. There is no tax adjustment: preferred dividends are paid out of after-tax profit, unlike interest.

Required return from the capital asset pricing model

required return = rf + β × (market return − rf)

rf
the risk-free rate, usually a long government bond
β
the asset's sensitivity to the market
market return
the expected return on the market portfolio

Used as the cost of common equity in a WACC. The bracket is the equity risk premium — the extra the market pays for bearing risk that cannot be diversified away. Beta prices only that part; risk specific to one company earns nothing, because a holder can diversify it away for free.

A practice question

From the question bank, with the reason each wrong option is wrong.

A preferred share pays a fixed $5 dividend and trades at $62.50. What is its cost?

  1. 8.00% — correct
  2. 12.50%Why not: Divides the price by the dividend rather than the dividend by the price.
  3. 5.00%Why not: The dividend amount read as a percentage, with no reference to what the share costs.

A fixed perpetual dividend divided by price gives 5 ÷ 62.50 = 8.00%. The dividend amount alone is not a rate.

A harder one

Which two approaches are commonly used to estimate the cost of common equity?

  1. The yield to maturity and the coupon rateWhy not: Both are debt measures and rest on a contractual payment, which common equity does not have.
  2. CAPM and the dividend discount model rearranged for the required return — correct
  3. The payback period and the internal rate of returnWhy not: Project appraisal measures. They evaluate an investment rather than estimate a required return.

Common equity has no promised payment, so its cost is inferred either from systematic risk via CAPM or from the dividend yield plus expected growth.

The hardest tier

Why is equity structurally more expensive than debt for the same company?

  1. Because equity issuance costs are regulatedWhy not: Issuance costs are real and are a one-off, not the reason the ongoing required return is higher.
  2. Because dividends must legally exceed interestWhy not: No such rule exists, and many companies pay interest while paying no dividend at all.
  3. Equity ranks last and its return is not deductible — correct

Residual claimants demand a higher return for taking first losses, and unlike interest, their return carries no tax shield. Both effects push in the same direction.

In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.

Take the free diagnostic →

More in Capital Structure