What is a Cumulative Preferred Stock?
It is a type of preferred stock with a caveat that if any dividend payment was missed in the past due to lack of sufficient profits, it should be paid first to the preferred stockholder in the subsequent periods when there are adequate profits. In order of seniority also, this type of shareholders are settled before other preference shareholders and common stockholders in an unfortunate event of liquidation.
The dividend on these type of stocks accrues even if the dividend is not declared by the company in particular year unlike the non- cumulative preferred stock where the payment is dependent on whether the dividend is declared or not. Preferred stock is presumed to be cumulative until and unless specified.
Cumulative Preferred Stock – An Example
If a company issues a cumulative preferred stock with a par value of $1000 and the annual dividend rate was set at 8%. The next year the market conditions worsen and the company decides to pay half of the dividend accrued and pays $40. The next year situation fails to improve and company cannot pay the dividend at all, hence the total amount which company now owes to a preferred stockholder is $120. But the following year situation improves and the company decides to pay the dividend. The preferred stockholders must be paid $120 in arrears along with current year dividend of $80. Once all cumulative preferred stockholders are paid $200, the company may begin to pay other shareholders. Following is the tabular expression of cumulative dividends in preferred.
|Year 1||Year 2||Year 3|
Cumulative Preferred Stock vs. Common Stock
The primary difference between the two is the obligation to pay a dividend. It is not obligatory for the management to pay the dividend to common stock whereas the dividend in case of cumulative preferred stock can be delayed or partly paid but cannot be completely avoided. In a profit making corporation, equity stockholders are benefited as they get dividends or capital appreciation based on the profits of the corporation whereas the preferred stockholders would get the fixed rate of dividend irrespective of profitability of the business.
Cumulative Preferred Stock vs. Debt (Bonds or Debentures or Loan)
The obligation to pay the dividend is fixed in cumulative preferred stock but it can be delayed or partly paid. Whereas, in case of any kind of debt, the interest payment is compulsorily be paid in the year of accrual. If it is delayed, the corporation can fall under the definition of bankruptcy.
Advantages of Cumulative Preferred Stock
- This type of preferred stock provides investors with security and their investment is less likely to suffer volatility in the longer term.
- They are a comparatively secured investment. Since they do not lose the dividend on account of poor performance by the company in a particular year the investors are more assured of their returns.
- Ranked higher to common stock in case of insolvency.
- Since these instruments allow dividends to cumulate, the rate offered to them vis-à-vis their Non-Cumulative counterparts, is much lesser, hence these instruments help companies to bring down their cost of equity.
- The management achieves the benefit of the flexibility of dividend payment along with financial leverage which in turn results in wealth maximization of its equity shareholder.
Disadvantages of Cumulative Preferred Stock
- The dividend rates remain stagnant in these types stocks i.e. they will receive same dividend rate irrespective of the business profitability. They are just named as shareholders but do share profits in a true sense.
- When these instruments are issued, the dividend rates are placed more than current prevailing interest rates to win investor’s preference over debt investments. In a rising interest rate situation, the investment in these stocks loses charm. On the contrary, if the interest rates are falling, they become a good investment.
- Although the preferred stock is categorized under equity, they these stockholders do not enjoy voting rights.
- Their value hardly rises in such a scenario since the other bonds with higher yields are available.
- These types of stocks are subordinate to bonds and hence in case of insolvency, they are ranked after bondholders.
- Most of these stocks have a call feature as well though with some call protection, which is a significant risk if the interest rate falls down in medium to a long-term time frame.
- Dividends are fixed obligations like interest on the debt. The only difference between a debt obligation and preferred stock is that the preference dividend can be delayed but interest cannot be.
- They are a costly source of finance compared to debt.
See how to calculate the Cost of Preferred Stock to a corporation.
The formula for calculating the dividend in these instruments is as follows:
Annual Dividend = (Rate)*(Par Value)
If the payment frequency is quarterly, the dividend paid every quarter is
Quarterly Dividend = (Annual Dividend) / 4
If the company misses payment 3 times, then the arrears would be
Dividend Arrears = 3*(Annual Dividend)/4
So, Total Dividend Accrued (to be paid) = 3*(Annual Dividend)/4 + (Annual Dividend) / 4
The cumulative preferred stock appears in the stockholder’s equity on the balance sheet and sometimes it is also mentioned in the notes to the balance sheet.
As far as the sequence of dividend payment is concerned, as per the accounting procedures, the arrears should be paid first and then the current year’s dividend payments, hence the logic is to start with the oldest pending payment and move towards the latest.Last updated on : March 1st, 2018