In this lesson, you will learn the most important characteristics of cumulative preferred stock and its advantages and disadvantages. You will also learn financial formulas applied to cumulative preferred stock.
If you are an investor, one of your investment objectives might be to have a steady stream of dividend income.
A preferred stock investment might be the answer to your needs. Corporations issue preferred stock because the equity market may not be receptive to a new issue of its common stock or lenders may believe the company needs an equity infusion before it becomes creditworthy.
Cumulative and Non-Cumulative Preferred Stock
To ensure investors of the stream of dividends, most preferred stocks are cumulative preferred stock. Cumulative preferred stock requires not only the current year dividend, but any dividends in arrears, be paid before common shareholders receive dividends. Dividends in arrears are contractually required dividends for prior years that have not been paid to the preferred shareholders. Non-cumulative preferred stock requires only the current year’s dividends be paid to the preferred shareholders before the common shareholders receive dividends.
Interest payments on debt, such as bonds payable or a bank loan, are legally enforceable. A board of directors cannot be forced to declare a dividend and sometimes will not if the company’s cash flow does not support the dividend payment. Therefore, it is not completely certain a preferred stock investor will not receive dividends.
Formulas and Examples
There are several simple formulas an investor in cumulative preferred stock should know. First, calculate the preferred stock’s annual dividend payment by multiplying the dividend rate by its par value:
|Annual preferred stock dividend = Par value x Dividend rate|
Assume you have a share of cumulative preferred stock with a par value of $1,000 and a 10% dividend yield. The annual dividend is $100 ($1,000 par value times 0.10).
You then calculate the quarterly dividend by dividing the annual dividend by four:
|Quarterly preferred stock dividend = Annual preferred stock dividend / 4.|
In this case, the quarterly dividend is $25 ($100 as calculated above divided by 4).Multiply the number of dividends in arrears (missed dividend payments) by the quarterly dividend amount to calculate the cumulative preferred dividends per share that must be paid before common shareholders can receive any dividends:
|Cumulative dividends per share = Current period quarterly dividend + (Number of dividends missed x the Quarterly Dividend)|
Suppose four dividend payments have been missed. The amount of cumulative dividends per preferred share is $125.
This includes the current period dividend of $25 plus the dividends in arrears of $100 (four quarters x $25 quarterly dividend). In some cases, the preferred stock contract will provide for interest payments on dividends in arrears, giving investors further insurance they will be adequately compensated for their investment.
Advantages and Disadvantages
Preferred shareholders always want to have a cumulative feature. This can negatively affect the common shareholders, though. A growing company with dividends in arrears may not pay common shareholders dividends for years.
Suppose the $125 convertible preferred dividend per share exhausts the cash available for dividends that year. Preferred shareholders would receive dividends but the common shareholders would not. Therefore, the common shareholders always want preferred stock to be non-cumulative. Whether the preferred stock is cumulative or non-cumulative is determined by the demand for the company’s stock and other features of the preferred stock issue.
Preferred stockholders must receive any dividends before common shareholders. Cumulative preferred stock requires that dividends for the current year and any unpaid dividends from prior years be paid to preferred stockholders before the common shareholders receive any dividends.
Non-cumulative preferred stock shareholders are only entitled to receive current year dividends before common shareholders may be paid dividends. Preferred shareholders always want their preferred stock to be cumulative, while common shareholders want any preferred stock issue to be non-cumulative.