Preferred Stock dividends - FCFF/E

CFA Level II
#1

How do we treat P/S dividends in FCFF and FCFE?

#2

remove them from FCFF since they are a use of cash and contractual, in essence they are not free

#3

Treat preferred stock like debt, except preferred stock are not tax-deductible. Preferred dividends are added back to FCFF. This is assuming that Net Income calculated is to equity shareholders after dividends have been subtracted out. FCFF = NI + NCC + Int(1-tax rate) + preferred dividends - FCInv - WCInv The only adjustment to FCFE would be modify net borrowing to reflect new issuance by the amount of preferred stock. FCFE = FCFF - Int(1-tax rate) - preferred dividends + Net borrowing + Net issuance of preferred stock

#4

thanks idreesz, thats what i thought. so its basically treated just like debt, except there’s no tax benefit. Would’ve looked this one up myself, but i’m sitting here at my desk and it just kinda popped in there. This damn test is taking over my brain…

#5

yes you add them back you do not subtract them yes, they are essentially debt but without the tax benefit since preferred shareholders loaned “perpetual” capital to the firm, and the dividends are the interest…thats how i look at it.

#6

agree with idreesz, that’s what I was thinking too. add them back to FCFF, but I wouldn’t consider them equity, so don’t include them in FCFE

#7

Just think of the priority of claimholders: Debt —> Preferred Equity --> Common Equity Debholders are first in line so it has no effect on FCFF. It will affect FCFE since preferred shareholders will have to be paid prior to common shareholders.

#8

preferred stocks are issued to equity holders, which should also be included into “cash flow to equity holders” so just remember: FCFE = FCFF - Int(1-tax rate) - preferred dividends(consider the same as interest payout) + Net borrowing + Net issuance of preferred stock

#9

there is a nice EOC problem set in Schweser and CFAI on this. You need to adjust your WACC for FCFF as well.