Cumulative preferred stock refers to a type of preferred stock that entitles its holders to receive unpaid dividends before any dividends are paid to the holders of common stock. Unlike non-cumulative preferred stock, which does not accumulate or carry forward any unpaid dividends, cumulative preferred stock ensures that any skipped or unpaid dividends are accumulated and must be paid in full before any distributions are made to common stockholders.
Explanation:
Cumulative preferred stock is often issued by corporations as a means of attracting investors and providing them with a greater sense of security. It offers stockholders a preferential claim to dividends, typically at a fixed rate, before any distribution can be made to common shareholders. This fixed rate is predetermined and specified in the issuance agreement.
In the event that a company fails to pay dividends on cumulative preferred stock in any given year, the unpaid dividends accumulate and are known as cumulative arrears. The outstanding cumulative arrears must eventually be paid back with future dividends, even if the company has resumed paying dividends to its common stockholders.
This unique feature of cumulative preferred stock distinguishes it from other types of stock, such as non-cumulative preferred stock or common stock, which do not carry forward any unpaid dividends. If a company decides not to pay dividends to non-cumulative preferred stockholders in a particular year, those dividends are forever lost to the stockholders.
Furthermore, when a company experiences financial difficulties and suspends dividend payments, cumulative preferred stockholders have the right to claim both the current year’s dividends and the accumulated unpaid dividends from previous years before any dividends are distributed to common stockholders. This ensures that cumulative preferred stockholders have priority in receiving their dividends and are protected from potential losses.
In terms of liquidation, cumulative preferred stockholders have a higher claim on the company’s assets compared to common stockholders but are subordinate to bondholders and other creditors. In the event of bankruptcy or liquidation, cumulative preferred stockholders have the right to receive their investment back before common shareholders but after the company’s debts, including bond obligations, have been settled.
Overall, cumulative preferred stock provides investors with a more reliable income stream compared to common stock. However, the trade-off is that cumulative preferred stock typically offers lower potential returns compared to common stock, as its dividend rate is usually fixed and does not participate in the company’s profits beyond that predetermined rate.
Usage:
Investors seeking a steady income flow with a degree of safety often choose to invest in cumulative preferred stock. The cumulative feature of this stock offers protection and may be particularly attractive for risk-averse investors who prioritize stable dividends over potential capital appreciation.
Example:
Company A, facing financial difficulties during an economic downturn, suspends dividend payments to its common shareholders. However, holders of cumulative preferred stock remain entitled to receive their unpaid dividends, including the accumulated arrears from previous years, once the company’s financial condition improves and dividend payments are resumed.
In conclusion, cumulative preferred stock is a type of preferred stock that ensures its holders are entitled to receive any unpaid dividends in the future. It offers investors a predictable income stream and a sense of security compared to other types of stock. The cumulative feature distinguishes it from non-cumulative preferred stock and provides investors with the assurance that their unpaid dividends will eventually be paid in full.