Understanding Cumulative Preference Shares: Definitions, Procedures, and Benefits
Cumulative preference shares are a special type of preferred stock that ensure shareholders receive dividends on a cumulative basis, even if a company is not profitable in certain years. This article will explore the definition, procedures, and benefits of cumulative preference shares, along with an example to illustrate the concept.
What are Cumulative Preference Shares?
The holders of cumulative preference shares are entitled to receive cumulative dividends, even if the company is not profitable. During years in which the company is not profitable, these dividends are counted as arrears. In the year when the business is profitable, these arrears must be paid in full before any dividends can be distributed to other shareholders.
The Procedure for Cumulative Preference Shares
Example Illustration
Let's use an example to help you understand the concept. Suppose a company offers cumulative preference shares for Rs 1000 apiece with a 10% dividend guarantee. In the first year, the economy and the business are financially sound, and the business pays the dividend in full. The result is that Rs 100 is given to the cumulative preferred shareholder.
Unfortunately, the economy weakens in the second year, and the business can only afford to distribute Rs 50 as the dividend. In the third year, the business situation worsens even further, and the firm stops paying dividends. At this point, the shareholder is entitled to Rs 150 in arrears, Rs 100 for the third year, plus the remaining Rs 50 from the second year.
When the economy starts to improve in the fourth year, and dividend payments begin again, the business is obligated to provide cumulative preferred shareholders Rs 150 in back payments, along with a Rs 100 dividend for the next year. The corporation must pay cumulative preferred stockholders before paying a dividend to any other classes of shareholders.
Benefits of Cumulative Preference Shares
Flexibility in Dividend Payment
One major benefit of cumulative preference shares is that the company can postpone the payment of dividends if necessary. This flexibility does not place an undue burden on the company's finances. The company can choose to pay dividends when profits are available, without compromising its financial stability.
No Mortgage or Charge on Assets
Cumulative preference shares do not create a mortgage or charge on the company's assets. This means that the company can keep its fixed assets free for future financing needs or loan raising purposes. This helps in maintaining a strong balance sheet and improving the company's capital structure.
Fixed Dividend Rate
Another significant advantage is that the company pays a fixed rate of dividend on these shares, which provides a certain level of predictability and security for the investors. This fixed rate ensures that investors have a guaranteed return on their investment, which can be particularly attractive to conservative investors.
Non-Voting Rights
Typically, cumulative preference shares do not come with voting rights. This means that a company can raise capital without the risk of losing control to external investors. The company remains under the ultimate control of its equity shareholders, ensuring that management can make decisions independently of outside influences.
Incentivizing Investors
Cumulative preference shares also incentivize investors with the promise of a minimum return on investment. If preferred shares are cumulative, all past suspended payments must be made to preferred shareholders in full before common stockholders can receive anything at all. This ensures that preferred shareholders are protected and their investment is secured.
Additionally, if a company is unable to pay cumulative dividends by their due date, it may have to pay interest on future payments, further reinforcing the protection of preferred shareholders' rights.
Conclusion
Cumulative preference shares are a valuable tool for companies seeking to attract stable, long-term investors. By providing a guaranteed dividend and the flexibility to manage dividend payments during lean years, these shares offer both benefits to investors and advantages to the company.
For more details and assistance with your financial strategies and investment portfolio, consider consulting with a financial advisor or expert in investment and corporate finance.