Understanding Cumulative Dividends in Preference Shares

Unveiling Preference Shares: Understanding Cumulative Dividends

Preference shares, also known as preference stocks or preference capital, are a specific type of equity investment that offers unique benefits and risk-return characteristics. One of the defining features of preference shares is their ability to provide cumulative dividends, which are the focus of this article.

What are Preference Shares?

Preference shares are a hybrid security, possessing elements of both debt and equity. They typically offer a fixed dividend rate, making them less risky than common stock but not as secure as fixed-income bonds, as dividends are not guaranteed. They are often used to raise capital for companies, allowing them to issue shares that are subordinate to common stock (in terms of dividends and liquidation) but offer a fixed return and priority over bonds in the event of liquidation.

Cumulative Dividends

Cumulative preference shares hold a special dividend feature where any missed dividend payments accumulate until they're paid off before the shareholders receive any common stock dividends. This creates a bond-like characteristic, as it guarantees that shareholders will receive their dividends eventually, even if the company misses a payment or two.

Cumulative preference share dividends can be paid in cash or in the form of stock. When paid in stock, the company issues additional preference shares to shareholders, which can be called "scrip" dividends. The amount of stock issued is typically equal to the missed dividends' value.

How Cumulative Dividends Work

Let's say we have a company that issued cumulative preferred shares. If the company misses a dividend payment, that missed dividend amount will be added to the cumulative dividend amount owed to shareholders. The cumulative dividend amount represents the total amount of missed dividend payments that the company owes to shareholders.

For instance, if the preferred shares have a $5 annual dividend, and the company misses two annual dividend payments, the cumulative dividend amount owed to shareholders would be $10 ($5 x 2).

If the company starts paying the dividends again, it must pay the cumulative dividend amount before it pays any dividends to common stock shareholders.

Advantages of Cumulative Dividends

Cumulative dividends offer several advantages for both companies and investors:

1. Investor Protection: Cumulative dividends provide investors with a guarantee of receiving their dividends eventually, even if the company misses a few payments.
2. Lower Interest Rates: Companies may be able to issue preference shares with lower dividend rates compared to bonds because the risk of non-payment is lower due to the cumulative dividend feature.
3. Income Stability: Preference shares with cumulative dividends can offer a relatively stable income stream for investors.

Disadvantages of Cumulative Dividends

However, some potential drawbacks should also be considered:

1. Lower Dividend Growth: The fixed dividend rate can lead to lower dividend growth compared to common stock.
2. Higher Dividend Distributions: Companies must pay the cumulative dividend amount before they pay dividends to common stock shareholders, which can increase the dividend distribution costs.
3. Investment Risk: Preference shares are still risky investments, as the company's ability to pay dividends can be affected by factors such as financial performance and economic conditions.

Conclusion

Cumulative preference shares are a unique type of investment that offers both equity and bond-like characteristics. Their fixed dividend rate and priority over common stock dividends make them an attractive option for investors seeking a stable income stream. However, investors must be aware of the potential risks and limitations associated with these investments. Understanding the concept of cumulative dividends is crucial for making informed investment decisions when considering preference shares.