Cumulative preference shares are a type of preferred stock issued by companies that offer specific advantages and characteristics compared to other types of shares. This article aims to explain cumulative preference shares in simple terms, provide references, and offer examples to help beginners understand this concept effectively.
Table of Contents
What are Cumulative Preference Shares?
Definition
Cumulative preference shares are a class of preferred stock where if the company fails to pay dividends on the specified payment date, the unpaid dividends accumulate and must be paid before any dividends can be paid to common shareholders. They are called “preference” shares because they have priority over common shares in receiving dividends and assets in case of liquidation.
Key Features
- Dividend Priority: Holders of cumulative preference shares have a priority claim on dividends over common shareholders. If dividends are not paid in a given period, they accumulate and must be paid in the future before any dividends can be paid to common shareholders.
- Fixed Dividend Rate: Cumulative preference shares typically carry a fixed dividend rate, stated as a percentage of the share’s par value.
- Non-Voting Rights: Unlike common shareholders, holders of preference shares generally do not have voting rights in corporate decisions.
Why are Cumulative Preference Shares Issued?
Attracting Investors
Companies issue cumulative preference shares to attract investors who seek regular income streams similar to bondholders but with the potential for higher yields than bonds issued by the same company.
Financial Flexibility
By issuing preference shares, companies can raise capital without diluting the ownership rights of existing common shareholders or taking on additional debt obligations.
Risk Management
For corporations, issuing cumulative preference shares allows them to manage their financial obligations effectively by structuring a portion of their financing as preferred equity rather than traditional debt.
How Do Cumulative Preference Shares Work?
Dividend Accumulation
If a company fails to pay dividends on cumulative preference shares in any given period, those dividends accumulate and become cumulative dividends. These accumulated dividends must be paid before any dividends can be distributed to common shareholders in future periods.
Example of Cumulative Preference Shares
Let’s illustrate with an example:
Scenario: Company X issues cumulative preference shares with a par value of $100 per share and an annual dividend rate of 6%. Investor A purchases 100 shares of this preference stock.
Dividend Payment Schedule:
- Year 1: Company X declares a dividend but does not have sufficient profits to pay dividends to preference shareholders.
- Year 2: Company X reports higher profits and declares dividends for both Year 1 and Year 2.
Outcome: In Year 2, before common shareholders receive any dividends, Company X must first pay the accumulated dividends for Year 1 to preference shareholders, amounting to $600 (100 shares × $100 par value × 6% dividend rate for Year 1).
Benefits and Risks of Cumulative Preference Shares
Benefits
- Stable Income: Preference shareholders receive regular dividend payments, providing a stable income stream.
- Dividend Preference: Priority in dividend payments over common shareholders increases predictability of income for investors.
- Capital Preservation: Cumulative feature ensures that missed dividends accumulate and must eventually be paid, reducing investor uncertainty.
Risks
- Interest Rate Sensitivity: Preference share prices can be sensitive to changes in interest rates, affecting their market value.
- Lack of Voting Rights: Preference shareholders typically do not have voting rights, limiting their influence on corporate decisions.
- Call Risk: Issuers may have the option to redeem preference shares at a predetermined price, potentially ending future dividend payments.
Real-World Applications
Corporate Finance
Companies across various industries issue cumulative preference shares to raise capital for expansion, debt repayment, or other corporate initiatives while managing financial obligations.
Investment Strategy
Investors seeking stable income with lower volatility compared to common stocks may include cumulative preference shares in their investment portfolios.
Conclusion
Cumulative preference shares offer investors a unique combination of steady income and dividend preference over common shareholders. Understanding their features, such as dividend accumulation and priority in dividend payments, is crucial for both investors and corporations issuing this type of equity. By considering the benefits, risks, and real-world applications of cumulative preference shares, stakeholders can make informed decisions in corporate finance and investment management contexts.