Should Preferred Stock Be Part of Your WACC Calculation? A Complete Guide

When building valuation models or making capital allocation decisions, investors and analysts face a critical question: does preferred stock belong in the weighted average cost of capital formula? The short answer is yes—if preferred shares represent a material portion of how a company finances its operations, they should be incorporated as a distinct component. This guide walks through the mechanics, the math, the tax implications, and most importantly, the practical judgment calls you’ll need to make.

Why WACC Matters in the First Place

Before diving into preferred stock specifics, it’s worth stepping back. Weighted average cost of capital measures the average return a company must pay to all its sources of financing—debt holders, preferred shareholders, and common equity investors. Think of it as the discount rate that reflects what each dollar of capital costs the business.

In corporate valuations, whether you’re pricing an acquisition, evaluating a capital project, or assessing fair value for financial reporting, WACC serves as the discount rate that converts future cash flows into present value. It’s the bridge between your earnings projections and your valuation conclusion.

The formula captures three components when all are present:

• Cost of debt (reflecting interest payments and their tax benefit)
• Cost of equity (reflecting returns required by common shareholders)
• Cost of preferred (reflecting returns required by preferred shareholders)

Each component is weighted by its market value share of total capitalization. This weighting ensures the formula reflects the company’s actual funding mix.

The Preferred Stock Problem: Why It’s Often Overlooked

Preferred stock sits in an awkward middle position. It’s senior to common equity in bankruptcy proceedings but junior to debt. It pays fixed dividends like a bond but isn’t legally debt. This hybrid nature creates ambiguity—which is why many analysts either ignore preferred entirely or struggle with how to treat it.

The result: inconsistent WACC calculations that can either overstate or understate the true cost of capital. When preferred is material (say, 5% or more of total capitalization), omitting it biases your valuation in predictable ways.

The Fundamental Difference: Preferred Dividends and the Tax Shield

Here’s the critical distinction that most textbooks emphasize but practitioners sometimes forget: debt interest is tax-deductible, but preferred dividends are not.

When a company pays $100 in interest on debt, it reduces taxable income by $100. If the corporate tax rate is 25%, this saves $25 in taxes—a real cash benefit. The after-tax cost of that debt is lower because of this shield.

Preferred dividends work differently. When a company pays $100 in preferred dividends, this comes from after-tax earnings. There’s no reduction in taxable income, no tax shield, no advantage. The full $100 represents a genuine cost to the company.

This distinction flows directly into your WACC formula. The debt component is multiplied by (1 − tax rate) to reflect the tax benefit. The preferred component is not. It stands alone at its stated rate, because preferred shareholders don’t benefit the company’s tax position.

The WACC Formula with Preferred Stock Included

Most textbook formulas ignore preferred because it’s immaterial or absent in the problem set. The “real world” formula that captures what most practitioners use is:

WACC = (E / V) × Re + (D / V) × Rd × (1 − T) + (P / V) × Rp

Where:

• E = market value of common equity
• D = market value of debt
• P = market value of preferred stock
• V = total market value (E + D + P)
• Re = cost of equity
• Rd = pre-tax cost of debt
• Rp = cost of preferred (preferred dividend yield)
• T = corporate tax rate

The weighting ensures each capital source’s contribution to overall cost reflects its proportion of the funding mix. The tax factor (1 − T) applies only to debt; preferred and equity get no tax adjustment.

Measuring What You Need: Market Values and Weights

To build this formula, you need actual numbers. Most practitioners use market values—current trading prices—rather than accounting book values, because market values reflect what investors today believe those securities are worth.

For common equity, market value is straightforward: shares outstanding multiplied by current stock price. This gives you E.

For preferred stock, if it trades publicly, use the current market price per preferred share times shares outstanding. If preferred is thinly traded or newly issued with no active market, use the issuance proceeds (net of fees) as a proxy. For established preferred without a quoted price, a recent transaction or appraisal may be necessary.

For debt, use the market value of interest-bearing obligations. If bonds trade actively, use their market price. If not, book value often serves as a reasonable proxy—though with a caveat that long-term debt prices can diverge from par.

Adding these three gives you V, your total capitalization.

The weights (E/V), (D/V), and (P/V) then tell you what slice of total financing each source represents. These weights should sum to 100%.

Why market values instead of book values? Market values reflect current investor expectations about future risk and return. Book values reflect historical cost and accounting choices that often bear little relation to today’s economic reality. Using book values can systematically bias your WACC and therefore your valuation.

Calculating the Cost of Preferred

Once you’ve established the market value of preferred (P), the next step is determining its cost (Rp).

For a perpetual preferred with a fixed dividend, the formula is simple:

Rp = Annual Preferred Dividend / Current Market Price of Preferred

Example: A preferred stock pays $4 per share annually and trades at $80. The cost is 4 ÷ 80 = 5%.

For a recent issuance without an active market price, use the net proceeds (price minus underwriting fees) in the denominator instead.

This approach mirrors a dividend yield calculation. It answers: “What return is the preferred shareholder currently earning on their investment?” That return is what the company must pay going forward to retain preferred capital.

Complications arise with special features. A callable (redeemable) preferred has a call date set by the issuer; the holder might be forced out before perpetuity. In such cases, use yield-to-call rather than perpetual yield. A convertible preferred embeds an option to convert into common stock, which reduces the required yield because investors value the conversion option. A floating-rate preferred pays a variable dividend tied to a market index, so you’d use an expected forward rate rather than a fixed number.

The key principle: Rp should reflect the yield required by preferred shareholders after accounting for all features and risks specific to that preferred. Ignoring call risk, conversion optionality, or dividend growth understates or overstates true Rp.

When to Include Preferred, When to Simplify

The decision to include preferred as a separate WACC component hinges on materiality and purpose.

Include preferred explicitly when:

• Preferred shares are outstanding and actively traded or recently issued with known pricing
• Preferred represents 5% or more of total capitalization
• You’re building a detailed firm valuation (DCF of free cash flow to firm) where precision matters
• The preferred has unusual features (convertible, callable) that affect risk and return significantly

Simplify (fold preferred into equity) when:

• Preferred is less than 2–3% of total capitalization and its omission would not meaningfully affect valuation
• You lack reliable preferred pricing data and the research cost exceeds the benefit
• You’re doing a preliminary screening or rough valuation where order-of-magnitude accuracy suffices
• The company has thinly traded, immaterial preferred where sourcing accurate Rp is difficult

The practical rule of thumb: If preferred is roughly 5% or more of V, treat it seriously. If it’s clearly immaterial, document your simplifying assumption and move on. The key is transparency—disclose what you did and why, so readers understand your approach.

A Worked Example: Putting It Together

Imagine you’re valuing a utility company with a capital structure that includes preferred:

Other inputs:

• Cost of equity (Re) = 8%
• Pre-tax cost of debt (Rd) = 4%
• Cost of preferred (Rp) = 6% (from dividend / price)
• Corporate tax rate (T) = 21%

Step 1: Calculate weights.

• E/V = 500 / 800 = 62.5%
• P/V = 100 / 800 = 12.5%
• D/V = 200 / 800 = 25%

Step 2: Apply the formula. WACC = (0.625 × 8%) + (0.125 × 6%) + (0.25 × 4% × (1 − 0.21)) WACC = 5.0% + 0.75% + (0.25 × 4% × 0.79) WACC = 5.0% + 0.75% + 0.79% WACC = 6.54%

Compare this to what you’d get if you ignored preferred entirely and reweighted only equity and debt:

• E/V (new) = 500 / 700 = 71.4%
• D/V (new) = 200 / 700 = 28.6%
• WACC (no preferred) = (0.714 × 8%) + (0.286 × 4% × 0.79) = 5.71% + 0.90% = 6.61%

The difference looks small (6.54% vs 6.61%), but when applied to a $5 billion firm or a multi-year cash flow stream, that 7 basis point difference compounds into meaningful valuation impact. For utilities and dividend-heavy sectors where preferred is common, including it is standard practice.

Preferred’s Relationship to Equity Valuation Methods

One source of confusion: when should preferred appear, and when shouldn’t it?

When valuing the firm (discounting free cash flow to all investors): Include preferred in WACC. You’re discounting cash available to debt holders, preferred shareholders, and equity holders, so their collective required return must be weighted into your discount rate.

When valuing common equity alone (discounting dividends to common shareholders): Don’t include preferred in your cost of equity formula—it’s not a required return for common holders. However, the presence of preferred in the capital structure may affect the risk you assign to common equity (leverage ratios, interest coverage) and thus indirectly influence the cost of equity estimate. If preferred is large, it reduces the equity cushion and increases common equity risk.

When modeling enterprise value, then working down to equity value: Include preferred as part of WACC for enterprise value, then subtract both debt and preferred market value to arrive at common equity value. Preferred holders have a claim junior to debt but senior to equity, so they must be “removed” from enterprise value before arriving at what’s left for common shareholders.

Handling Complex or Unusual Preferred Securities

Not all preferred is straightforward perpetual fixed-dividend stock. Market practice has evolved:

Convertible preferred: Includes an embedded option to convert to common shares. The conversion feature is valuable to the holder—it provides upside participation if the common stock rises. This reduces the required yield compared with non-convertible preferred. To estimate Rp, you might:

• Use the market yield observed for similar convertible instruments
• Build an option-adjusted model that values the straight preferred component plus the embedded option separately
• Adjust Rp downward from what a non-convertible preferred of similar features would require

Redeemable/callable preferred: The issuer has the right to redeem at a call price on or after a stated date. This limits the upside for preferred holders and increases their risk. Use yield-to-call (similar to yield-to-maturity on a bond) rather than perpetual yield. A callable preferred with a near-term call date might be treated almost like debt in its cost estimation.

Floating-rate preferred: Dividends reset periodically (e.g., quarterly) based on a market index or spread. Rather than a fixed Rp, use the expected forward rate or a market-implied rate for similar floating-rate securities. Update this estimate as market conditions change.

Cumulative preferred: Unpaid dividends accrue and must be paid before common shareholders receive anything. This doesn’t change Rp calculation, but it does mean that in your cash flow modeling, you must account for the obligation to eventually settle past-due dividends.

In each case, the principle remains: measure Rp to reflect what preferred holders actually require given the instrument’s features, and apply that rate without a tax adjustment.

Common Mistakes and How to Avoid Them

Mistake 1: Using book values for weights. Book equity, book debt, and book preferred are often poor proxies for market values. A equity-heavy balance sheet by book value might represent far less of true economic capital if stock prices have risen. Using stale book values biases your WACC. Always source market values where possible; document when you use book value as a proxy and flag the approximation.

Mistake 2: Applying the tax shield to preferred. This is surprisingly common. Preferred dividends are not tax-deductible. Do not multiply Rp by (1 − T). Only debt gets the tax adjustment. One way to remember: preferred is paid from after-tax earnings, debt is paid from pre-tax earnings.

Mistake 3: Omitting material preferred and pretending capital structure is just debt + equity. When preferred is 5%+ of capitalization, ignoring it skews your inputs and your conclusions. If you must exclude it for data availability, say so explicitly and test sensitivity.

Mistake 4: Using stale prices or wrong proxies for Rp. If preferred hasn’t traded in years, using an issuance price from a decade ago likely overstates or understates true cost. Try to find recent transaction data, comparable securities, or if all else fails, explain your proxy and the margin of error.

Mistake 5: Not distinguishing between WACC (for firm valuation) and cost of equity (for equity valuation). Preferred goes into WACC, not into cost of equity. If you’re discounting dividends to common shareholders only, use cost of equity; preferred remains in the capital structure but not in the denominator of your valuation formula.

Best Practices Checklist

• Source market data. Obtain current market prices for E, P, and D whenever possible. Document dates and sources.
• Calculate weights correctly. Sum E + P + D to get V; divide each by V to get percentages that sum to 100%.
• Do not tax-adjust preferred. Rp stands alone; (1 − T) applies only to Rd.
• Update regularly. WACC inputs change quarterly (market prices) and annually (tax rates). Don’t use stale inputs.
• Disclose assumptions. Explain where you got P, how you estimated Rp, and any simplifying choices.
• Run sensitivity. Test how WACC and valuation change if Rp, preferred weight, or tax rate moves by 50–100 basis points.
• Align preferred treatment across metrics. If you treat preferred as equity-like for capital structure analysis, be consistent when you measure leverage or when you model distributions.

Implications for Your Valuation and Decisions

Including preferred in WACC lowers your discount rate if preferred cost (Rp) is lower than your alternative weighted cost would be. This increases enterprise value. Conversely, if Rp is high relative to costs of debt and equity, including it raises your discount rate and lowers valuation.

For acquisitions, omitting target preferred can lead to overpaying if preferred is material. The acquirer may inherit preferred obligations that reduce cash available to common equity. Buyers should explicitly model preferred redemption assumptions.

For capital budgeting (deciding which projects to fund), using a WACC that excludes material preferred sets a hurdle rate that’s too low. You might approve marginal projects that, when properly discounted at true WACC, destroy shareholder value.

For impairment testing in financial reporting, accurate WACC—including preferred—ensures fair value estimates meet accounting standards and withstand audit scrutiny.

The bottom line: accurate WACC improves the quality of your valuation and decisions across the firm.

Key Takeaways

1. Preferred stock belongs in WACC if it’s material (roughly 5%+ of capitalization) and represents a distinct financing source.

2. Preferred dividends are not tax-deductible. Unlike debt, preferred cost is not multiplied by (1 − tax rate).

3. Use market values, not book values, for calculating weights. They reflect current investor expectations.

4. Calculate Rp as dividend yield. Preferred annual dividend divided by current market price (or net issuance price) gives the required return.

5. Account for special features. Callable, convertible, or floating-rate preferred require adjusted yield estimates.

6. Disclose your treatment. Whether you include, exclude, or simplify preferred, explain your judgment.

7. Test sensitivity. Show how valuation changes if preferred cost or weight shifts, confirming the impact isn’t material or documenting why it is.

Following these principles ensures your WACC calculation and resulting valuations are defensible, consistent, and grounded in economic reality rather than accounting convenience.