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Ever wondered how some investors never miss out on dividends? Read more to find out how!
The stock market offers many investment options, each with its own rules and benefits. But have you ever heard of cumulative preference shares?
Cumulative preference shares are company stock that pays dividends regularly. Companies pay dividends on their profits. These shareholders are owed dividends even if the company loses money in a given year.
This blog post simplifies and engages cumulative preference share information.
What are cumulative preference shares?
Cumulative preference shares are a unique company investment with great benefits. They have higher dividend payouts and priority for dividend distribution and liquidation claims like regular preference shares.
The cherry on top: if the company can’t pay dividends in any year, they accumulate and must be paid later. You heard right! With cumulative preference shares, you practically guarantee future dividends.
Cumulative preference shares meaning explained
Consider cumulative preference shares a VIP pass. Besides fast concert entry, this pass guarantees a front-row seat and extra goodies. Investors get these ‘extra goodies’ as cumulative dividends.
If a company struggles and can’t pay dividends, you don’t lose out. When the company recovers, these unpaid dividends are paid.
Cumulative vs non-cumulative preference shares
If a non-cumulative preference share company loses money and skips dividends for a year, you won’t get paid. The chance to earn dividends for that year is gone!
Thus, if the company underperformed, you would not receive dividends and they would not be made up in future years. You can think of this as a one-time missed opportunity.
Conversely, cumulative preference shares are dividend piggy banks. The company doesn’t lose money if it can’t pay dividends for one year. Instead of paying dividends that year, they are saved.
They save, and when the company starts making profits again, it pays out those dividends plus the current year’s. It’s like your dividends are queuing up, waiting for their turn to be paid.
The cost of preference capital
What makes a company offer cumulative preference shares over other attractive methods? Is it expensive for them? How does it impact their financial planning?
Cost implications for companies
The cost of preference capital is an essential factor that companies consider when they decide to issue any type of shares. This cost represents investors’ required return on company preference shares.
Due to the accumulation feature that gives investors security, cumulative preference shares have a higher cost of capital than ordinary shares.
Why are they still attractive for companies?
Companies issue cumulative preference shares despite the higher cost. Why?
Because cumulative preference shares have a lower cost of capital. Businesses find this a balanced approach because they can offer investors something valuable without incurring high costs.
The balance of cost and benefit
It’s a win-win because cumulative dividends attract long-term, committed investors without raising capital costs.
Investors trade the security of accumulated dividends for a slightly lower dividend rate than non-cumulative preference shares.
So, the next time you see an investment opportunity in cumulative preference shares, remember that this option is not just a good deal for you but often also a sustainable choice for the company you’re investing in.
Example
Let’s consider a fictional company called HappyTech. HappyTech issues cumulative preference shares with a face value of ₹100 and promises to pay 5% of that value as dividends annually.
Imagine you bought 100 of these shares. The first two years are great, and you receive your dividends as expected, ₹5 per share each year. But in the third year, HappyTech goes through a tough time and can’t afford to pay dividends.
In the fourth year, HappyTech starts making profits again. Before they pay any dividends for that year, they first pay the dividends they couldn’t pay you the previous year. So, you’d receive ₹10 per share for the fourth year, covering both the missed and current year’s dividends.
| Year | Dividends per share | Total dividends for 100 shares |
| 1 | ₹5 | ₹500 |
| 2 | ₹5 | ₹500 |
| 3 | ₹0 | ₹0 |
| 4 | ₹10 | ₹1000 |
Advantages and disadvantages of cumulative preference shares
Advantages
- Secure dividends: Even if the company can’t pay dividends for a while, you’ll eventually receive them when it can.
- Priority over equity shareholders: If a company is liquidated, cumulative preference shareholders get their share before equity shareholders.
Disadvantages
- Lower dividend rate: Because you have the safety net of accumulated dividends, the company often offers a slightly lower dividend rate on cumulative preference shares than on non-cumulative preference shares.
- No voting rights: Like other preference shares, cumulative preference shares don’t come with voting rights.
Conclusion
Cumulative preference shares are like a treasure in the investment world, offering you a safety net for your dividends. They allow you to invest with the confidence that even if things go south for a while, you won’t lose out on your deserved share of the profits.
For companies, issuing these shares is a way to attract committed investors without relinquishing control. All in all, it’s a win-win situation for both parties.
So the next time you’re looking for a reliable and promising investment avenue, consider the special VIP ticket in the stock market world, the cumulative preference shares!
FAQs
Cumulative is also known as accumulative, implying a gradual increase or addition over time. Other synonyms include aggregate, amassed, and increasing. In the context of shares, it refers to dividends that accumulate if unpaid.
The formula for cumulative dividends from cumulative preference shares is
Cumulative Dividend = Preferred Dividend Rate Preferred Share Par Value
This means the dividends are calculated based on the dividend rate and the par value of the preferred shares.
Cumulative preferred stock, while offering guaranteed dividends, comes with risks. These include lower yields compared to other investments, limited voting rights, and susceptibility to interest rate fluctuations. Also, in the case of company liquidation, they rank after debt holders.
No, preference shares are not always cumulative. They can be either cumulative or non-cumulative. Cumulative preference shares accumulate unpaid dividends for future payment. Non-cumulative preference shares do not offer this feature; unpaid dividends are not owed.
Cumulative preference shares can be classified as either debt or equity based on the substance of the contract. If the issuer lacks the unconditional right to avoid delivering cash or another financial asset to settle an obligation, the shares are likely classified as debt.