Cumulative Preference Share
Definition
Cumulative preference shares (also known as cumulative preferred stocks in the USA) are a class of shares issued by companies that guarantee shareholders the payment of dividends in arrears. If a company does not have sufficient earnings to pay dividends in any given year, these dividends accrue and must be paid out in the future before any dividends are distributed to ordinary shareholders. This makes cumulative preference shares less risky regarding dividend payments compared to ordinary shares.
Examples
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Company A: Suppose Company A issues cumulative preference shares with a 5% annual dividend. If in Year 1, the company cannot pay the dividend due to insufficient earnings, the unpaid dividend will be carried forward to Year 2. If the company returns to profitability in Year 2, it must pay the cumulative dividends for both Year 1 and Year 2 before paying any dividends to ordinary shareholders.
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Company B: Company B has issued cumulative preference shares that promise shareholders a $2 annual dividend per share. If the company only pays $1 per share in a particular year due to financial difficulties, the remaining $1 will be added to the next year’s dividend. If the financial state improves, the company is obliged to pay the accumulated $1 along with the $2 for the new fiscal year, ensuring shareholders receive $3 per share.
Frequently Asked Questions
What happens if a company never returns to profitability?
If a company never returns to profitability, cumulative preference shareholders may never receive their accrued dividends. However, they typically still have a higher claim on any remaining assets if the company is liquidated compared to ordinary shareholders.
Are cumulative preference shares considered safer than regular preference shares?
Yes, cumulative preference shares are generally considered safer than non-cumulative preference shares because they guarantee that any unpaid dividends will be accrued and paid out before any dividends on regular preference shares or ordinary shares.
Can a company pay dividends to ordinary shareholders while owing cumulative dividends?
No, a company cannot pay dividends to ordinary shareholders until it has paid all accumulated dividends to cumulative preference shareholders.
Do cumulative preference shares have voting rights?
Typically, cumulative preference shares do not come with voting rights. However, the specific rights associated with these shares depend on the terms set out by the issuing company.
What is the difference between cumulative and non-cumulative preference shares?
The primary difference is that cumulative preference shares allow for dividends to be carried forward if they are not paid in any given year, whereas non-cumulative preference shares do not. If dividends on non-cumulative preference shares are not declared in a particular year, shareholders have no right to claim these dividends in the future.
Related Terms
- Non-Cumulative Preference Share: A type of preference share where missed dividend payments do not accrue.
- Ordinary Share: Shares that represent equity ownership in a company, giving holders voting rights and the right to dividends, albeit only after preference shareholders have been paid.
- Dividend: A distribution of a portion of a company’s earnings to its shareholders, usually in the form of cash or additional stock.
- Redeemable Preference Share: Preference shares that the issuing company can buy back at a predetermined price after a specified date.
Online References
- Investopedia - Cumulative Preferred Stock
- The Balance - Preferred Stock
- SEC - Investor Bulletin on Preferred Stocks
Suggested Books for Further Studies
- “The Intelligent Investor” by Benjamin Graham and Jason Zweig - A classic book on value investing that extensively covers different types of securities, including preferred shares.
- “Corporate Finance: A Focused Approach” by Michael C. Ehrhardt and Eugene F. Brigham - Comprehensive coverage on corporate finance, including capital structure and financing methods.
- “Investment Valuation: Tools and Techniques for Determining the Value of Any Asset” by Aswath Damodaran - Delivers robust methodologies on valuing various instruments, including preference shares.
Accounting Basics: “Cumulative Preference Share” Fundamentals Quiz
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