Preferred dividend and valuation

As per CFAI Volume 4 Page 299, section 3.1 second last paragraph “ NI= Net income to common shareholders after preferred dividend but before common dividends”.

In Explanation of Q#4 in CFAI on page 359 of Volume 4 it has been stated in last para that “ If a company pays preferred dividend and they were previously taken out when net income available to common shareholder was calculated , they are added back in equation to include them in FCFF”.

From statement in text I am getting idea that NI should be taken after preferred dividend whereas from explanation of question I am getting that if preferred dividend has been deducted then it should be added back.

Yes. Both statements are correct. NI should be taken after preferred dividend but preferred dividend should be there in FCFF. So, if we had deducated preferred dividend from NI, then we should include it back. Similar things we do to interest payment, depreciation etc.

You exclude preferred dividends when calculating ‘net income to common shareholders’ as preferred stock is not a component of common equity. Hence, the cash used to pay preferred dividends is not available to common stockholders.

FCFF is free cash flow available to all providers of capital. All providers of capital include: debt holders, preferred stockholders, and common stockholders.

So you guys are saying that:

If we are calculating FCFF then we will ADD preferred dividend, if it has already been deducted, and

If we are calculating FCFE then we will DEDUCT preferred dividend and

Preferred dividend will be added back in both cases - FCFE and FCFF if it had been deducted from NI. Assuming that we are considering preferred equity as equity. If it is considered as debt, then we should not add it back in case of FCFE.

Got you. Guys thank you very much for discussion.

hmm I have this hightlighted in bright pink in my notebook:

“Preferred stock is just like debt, execpt preferred dividends are not tax deductible”

To me this has several implications:

  • Preferred shares are “debt”
  • Dividends from preferreds are not tax deductible
  • For FCFF, have to adjust WACC to include cost of preferred debt
  • If preferred equity was issued in this period, it’s a net borrowing (addition to FCFE)

Galli, thank you for further explanation. S2000magician do you have something to add here?