Companies use different sources of capital to fund their investments. Choosing a particular source of capital, such as preferred stock or common stock, involves risk assessments both by companies on capital uses and by investors regarding their required investment returns. Therefore, whether one source of capital is more expensive than the other depends on the risk assessments, which can be expressed in the form of cost of capital. Retaining only a company’s residual earnings, common stock is considered more expensive than preferred stock that has the guarantee of receiving a fixed amount of dividends.
A standard capital structure includes the use of all four regular capital sources -- debt, preferred stock, retained earnings and common stock. In practice, companies may not use all the capital sources, depending on their funding needs and investor demands in the respective capital markets. However, relying on a single source of capital may expose companies to certain risks and drive up a company’s total cost of capital over time. For example, the relatively inexpensive preferred stock, as compared to common stock, may be attractive, but the burden of having to pay preferred dividends regularly could make a company vulnerable to occasional business setbacks, increasing future financing costs.
Capital Risk Assessment
In general, companies use debt to finance less risky investment projects, and they use equity, including both preferred stock and common stock, to support investments of potentially higher returns. Preferred stock often is viewed as a hybrid of debt and equity. Even though companies are obligated to pay regular preferred dividends at a fixed rate, they are not contracted to pay back principal capital at any future maturity date. Such a financing feature makes preferred stock less risky than the traditional equity of common stock, which has no contractual guarantee on receiving common dividends.
Cost of Capital
Cost of capital plays a role in deciding which source of capital to use. The lower the cost of capital used, the less demand there is on the target rate of return that an investment must achieve. Cost of capital is directly linked to the risk characteristics of the capital used. In general, common stock is considered more expensive than preferred stock, because common stock assumes more risk than preferred stock. The cost of capital to companies is also the rate of return for investors, the minimum return that companies must achieve from the use of investors’ capital.
Capital Cost Impact
Common stock generally is considered the most expensive source of capital, as companies often use it to fund their most risky investments, and investors use it to obtain the highest investment returns. Companies must generate a level of earnings growth from common stock investments to keep prices of common stock from falling. On the other hand, companies need to earn only a predetermined fixed rate of income to meet the required preferred dividends. The more expensive the cost of capital is, the higher the return companies must generate and the more pressure on company management.