Cumulative Preference Share

Published Apr 7, 2024

Definition of Cumulative Preference Share

Cumulative preference shares are a type of preferred stock that grants holders the right to receive dividends in arrears before any dividends can be distributed to common shareholders. If the issuing company is unable to pay the dividend in one year, it accumulates and must be paid in full in subsequent years before any dividends can be paid to common stockholders. This feature makes cumulative preference shares more attractive to investors who prioritize income security and dividend payments.

Example

Imagine a company, XYZ Corp., that has issued cumulative preference shares with an annual dividend rate of 5%. Suppose in 2021, due to financial difficulties, XYZ Corp. is unable to pay the dividend to its cumulative preference shareholders. In 2022, before XYZ Corp. can distribute any dividends to its common shareholders, it must first pay the 5% dividend for 2022 and also the missed 5% dividend from 2021 to the holders of its cumulative preference shares. Therefore, cumulative preference shareholders are in a less risky position regarding dividend payments, as they are entitled to their dividends, regardless of when they are declared.

Why Cumulative Preference Shares Matter

Cumulative preference shares are crucial for both investors and issuing companies. For investors, they provide a degree of protection for their income, ensuring they receive promised dividends even if the company experiences temporary financial difficulties. This makes these shares particularly appealing to risk-averse investors or those relying on dividends as a steady income source.

For companies, issuing cumulative preference shares can be a strategic move to attract investors looking for safer, income-generating investments. These shares can also be an efficient way to raise capital without sacrificing the company’s control, as preference shares typically do not come with voting rights, or they have fewer rights compared to common shares. However, the obligation to pay accumulated dividends before common dividends can put pressure on the company’s cash flow in lean times.

Frequently Asked Questions (FAQ)

What happens to the cumulative dividends if the company goes bankrupt?

In the event of bankruptcy, cumulative preference shareholders are positioned higher than common shareholders but below debt holders in the hierarchy for asset distribution. This means they have a priority claim over the assets of the company, but only after all debts have been satisfied. However, there’s still a risk that they won’t receive their accumulated dividends if the company’s assets are insufficient to cover its liabilities.

Can a company convert cumulative preference shares into common shares?

Yes, some cumulative preference shares come with a conversion option, allowing shareholders to convert their shares into common shares under specified conditions. This feature can be beneficial to shareholders if the value of common shares increases significantly, although it might dilute the existing common shareholders’ ownership.

How do cumulative preference shares differ from non-cumulative preference shares?

The key difference lies in the treatment of missed dividends. Cumulative preference shares accrue dividends that are not paid in the year they are due, and these accumulated dividends must be fully paid out before any dividends can be given to common shareholders. In contrast, with non-cumulative preference shares, if a dividend is skipped, it is not owed in the future. Non-cumulative shares are generally considered less protective for investors concerning guaranteed dividend payments.

Do cumulative preference shares always come with a fixed dividend rate?

Typically, cumulative preference shares have a fixed dividend rate, which makes them similar to fixed-income securities like bonds. This fixed-rate provides investors with a predictable income stream. However, some cumulative preference shares may have a variable or floating dividend rate, linked to benchmarks like the LIBOR or prime rate, adjusting with market conditions.