Cumulative preference shares are a sort of preferred stock with a unique feature: if a corporation fails to pay a dividend, the unpaid dividends accumulate and must be paid out before any dividends are given to common shareholders. This feature makes cumulative preference shares an appealing investment option for people looking for more stable and predictable returns.
Key Features:
- Dividend Priority: Cumulative preference shareholders are paid dividends before common stockholders. If dividends are missed or partially paid in any given year, the arrears build.
- Dividend Accumulation: Unpaid dividends are accumulated and carried over to subsequent years. The corporation must settle these arrears before distributing dividends to ordinary shareholders.
- Fixed Dividend Rate: Cumulative preference shares normally have a fixed dividend rate, ensuring investors receive a consistent income stream.
- Priority in Liquidation: In the case of a liquidation, cumulative preference shareholders have a stronger claim on assets than regular shareholders, although they remain subservient to debt holders.
Advantages
- Income Security: The accumulation feature ensures that shareholders receive their dividends when they are due, making these shares a consistent source of income.
- Lower Risk: The priority in dividend payments and liquidation minimizes risk when compared to common shares, making them a safer investment choice.
- Attractiveness to Investors: Companies can attract investors by giving cumulative preference shares, particularly those seeking consistent and predictable returns.
Cons
- Limited Upside Potential: Due to the fixed dividend rate, cumulative preference stockholders do not benefit from the company’s earnings increase over the agreed-upon dividend.
- Lack of Voting Rights: Cumulative preference shareholders usually do not have voting rights, which limits their influence over business decisions.
- Dividend Deferment: Companies may defer dividend payments during financial difficulties, resulting in a lengthy wait for accrued dividends to be paid.
Examples & Applications
- Utilities and Financial Institutions: These industries frequently issue cumulative preference shares due to their consistent earnings and capital requirements.
- Corporate Financing: Companies employ cumulative preference shares to obtain cash without diluting control because they often do not carry voting rights.
Conclusion:
Cumulative preference shares are an advantageous financial mechanism for both businesses and investors. They provide companies a flexible financing option, while investors receive a more stable and predictable return. However, investors should evaluate the trade-offs, such as restricted upside potential and a lack of voting rights. Overall, cumulative preference shares can be a good addition to a diverse investment portfolio, especially for risk-averse investors looking for consistent income.
