Cumulative Preference Shares come with an advantage that very few kinds of shares bring along. Such kinds of shares are beneficial, primarily, to long-term investors in the share market.
Done! Easy, right? Well, it is not that simple.
In this detailed review, we will understand how these shares work for you, how are the calculations made, its benefits, problems and a lot more.
But first, let’s start with the basics.
Preference shares, also known as preferred stock, are shares of a company where dividends are paid to the shareholders before the issuance to the common stockholders. In any given condition if the company reaches a situation of bankruptcy, the preference shareholders are the ones who will be paid first as compared to the common stockholders.
Most preference shares get a fixed dividend, whereas usually, common stocks do not. The preference shareholders don’t have any right to vote, as compared to common shareholders.
Cumulative Preferences Shares Meaning
Cumulative preference shares are the kind of shares where the holders have a right of dividend even if the company has missed to give them the dividends in the past. Wow, isn’t that amazing!
Besides, at times of fewer profits, the company may decide not to provide the dividends to its shareholders.
However, in future, when the situation improves then, they can schedule to give all the dividends in the form arrears to its cumulative preference shareholders.
For example, let us understand it through an example that if cumulative preference shares of ₹68000 are being issued by the company at an annual dividend rate of 8%. The market conditions deteriorate next year, and the owner decides to pay a percentage of an accrued dividend and needs to pay ₹27,200.
Next year, the situation doesn’t seem to improve, and the company will not be able to pay the dividend of any kind. Therefore, the total sum that the company now will give to a preferred stockholder is ₹8,160.
However, the situation improves the following year, and the company chooses to give the dividend. The arrears, of ₹8160, should be paid to preferred stockholders together with the current year dividend of ₹5,440.
After paying ₹13600 (₹8,160 + ₹5,440) for all cumulative chosen shareholders, the company can start paying other shareholders. The following was the cumulative dividend tabular articulation of preferred.
Cumulative Preferences Shares Calculation
Cumulative preference shares include provisions which need the owner to pay all dividends to the shareholders, even those that are omitted earlier and then give it to the common shareholders.
Such payments of dividends were guaranteed, although not always paid out only when due.
The moniker “dividends in the form of arrears” is assigned as unpaid dividends but must legally go into the current market owner when payment is made. Sometimes the holder of the whole sort of preferred stock receives extra compensation (interest).
Quarterly dividend = [(value at par) x (rate of dividend)]/4
Cumulative dividends for every share = quarterly dividend x Missed Payment Amount
Unpaid dividends are not issued to non-cumulative preferred shares.
This means that in any given condition if the company has not paid dividends in either given year, the non-cumulative preferred stock shareholders had no right or power to claim these forgiven dividends in the long run at any time.
Cumulative Preference Shares Vs Common Stock
The main difference between the two is the obligation to pay dividends. The management does not need to pay dividends to common stock while the dividend can be delayed and partially paid in the case of cumulative preferences shares. Therefore, the dividend cannot be completely avoided across the case.
In business-making company, equity shareholders are benefited by receiving dividends and capital appreciation based on the income of the corporation.
Whereas, the preferred shareholders will receive the set dividend rate irrespective of the earnings of a business.
Isn’t that exciting?
Preferred cumulative stock Vs Debt
To Cumulative preference shareholders, there is an obligation to pay them the dividends, but a relaxation that it can be delayed or being partly paid. Rather in any kind of Debt, it is mandatory to pay interest fee in the accrual year.
When it is delayed, the company may fall under bankruptcy logic.
Because the cumulative property reduces the risk of dividend for the people who want to invest, Cumulative preference shares can usually be offered at a lower rate of payment as compared to non-cumulative preferred stock.
Generally speaking, only blue-chip companies who have a strong dividend history can give preferred non-cumulative stocks without expanding capital costs.
Cumulative Preference Shares Advantages
Different parties get different sets of advantages from cumulative preferences shares. Here are the details:
Ranks higher to the common stock in case of insolvency.
It lets the investors feel safe, and the investment becomes less likely to be affected in the longer term from volatility.
They are just an investment that is comparatively secured. As they don’t lose dividend in a given year due to the company’s bad performance, investors are much more assured of the returns.
As these instruments enable the accumulation of dividends, the rate at which it is offered to them is lowered as compared to non- cumulative counterparts, thus helping companies to reduce their equity costs.
Management achieves its advantage of dividend payment versatility together with financial leverage that, in turn, leads to a maximization of all its shareholder’s riches.
Cumulative preference shares Disadvantages
At the same time, there is a set of disadvantages cumulative preferences shares carry. Here are the details:
The dividend rates in such kinds of stocks remain constant, i.e. they get the same dividend value regardless of the profitability of the company. They were merely called as shareholders, but in a real sense, they don’t share the profits.
As the issuance of these instruments takes place, dividend rates are placed more than the currently accepted interest rates to win shareholder preference over debt financing.
In an increasing situation of interest rates, people lose interest in these stocks. On the contrary, they became a great investment if the rate of interest falls.
Even though the preferred stock is classified under equity, the right to vote for these stockholders is not there.
Such types for shares are subordinate to bonds and therefore are classified according to bondholders in the event of insolvency.
Dividend formula of Cumulative preference shares
The formula in such instruments for calculating its dividend is as follows:
Annual Dividend = (Rate)*(value at par)
Unless the payment frequency is quarterly, each quarter the dividend paid would be:
Quarterly Dividend = (Yearly Dividend) / 4
In case the company fails to pay 3 times, the arrears will be
Dividend Arrear = 3*(Yearly Dividend)/4
Thus, Cumulative preference shares are good for the investors and people always invest in those shares where they are sure about the returns.
So, it is suggested that people should opt for Cumulative preference shares as it has many advantages as discussed above.
In case you are looking to invest in cumulative preference shares or the stock market in general, let us assist you in taking the next steps ahead: