Definition
A cumulative preference share is a type of preference share that entitles the owner to receive any unpaid dividends from previous years. Companies are not obliged to pay dividends on preference shares if there are insufficient earnings in a particular year. However, cumulative preference shares ensure that the unpaid dividends (in arrears) are accumulated and must be paid out before any dividends can be given to ordinary shareholders when the company returns to profitability. In the USA, such shares are known as cumulative preferred stocks.
Historical Context
Preference shares have been a part of the financial market for centuries, dating back to the 1800s. They have provided investors with a degree of security in dividend payouts, especially in times when a company may not have enough profit to distribute regular dividends.
Types of Preference Shares
- Non-cumulative preference shares: Do not carry forward unpaid dividends.
- Convertible preference shares: Can be converted into a specified number of ordinary shares.
- Participating preference shares: May receive extra dividends based on particular criteria.
- Redeemable preference shares: Can be bought back by the issuing company after a certain period.
Key Events
- Introduction in the 19th Century: Companies began issuing preference shares to attract investment while minimizing the risk of dividend obligations during lean years.
- Market Regulation: The establishment of various financial market regulations ensured that cumulative preference shareholders are given priority over ordinary shareholders in receiving dividends.
Detailed Explanation
Cumulative preference shares provide a financial safety net for investors by guaranteeing payment of dividends in arrears. When a company does not have enough profits to declare dividends, the unpaid dividends accumulate. Once the company becomes profitable again, these accumulated dividends are paid out before any dividends are distributed to ordinary shareholders. This arrangement benefits both the company and the investors by offering stability and a higher degree of trust.
Mathematical Models/Formulae
To calculate the accumulated dividends, use the formula:
Diagram: Dividend Payment Hierarchy
graph TD;
A[Company Profits] --> B[Cumulative Preference Shareholders]
B --> C[Ordinary Shareholders]
Importance and Applicability
Cumulative preference shares are critical in providing financial security to investors, especially during periods when the company’s profitability is uncertain. They ensure that investors are compensated for their patience and the risk they undertake in investing in the company.
Examples
- Example 1: A company issues cumulative preference shares with a fixed dividend of $5 per share. In a year when profits are low, the company does not pay dividends. The following year, the company makes enough profit, and it must first pay the $5 per share from the previous year before paying out any dividends to ordinary shareholders.
Considerations
Investors should consider the following when investing in cumulative preference shares:
- Company’s Profitability: The likelihood of future profits affects the guarantee of receiving accumulated dividends.
- Dividend Rate: Fixed dividend rates might not compete with inflation or other investment opportunities.
- Market Conditions: Economic downturns may delay dividend payouts.
Related Terms and Comparisons
- Ordinary Shares: Do not carry the same dividend guarantees as cumulative preference shares.
- Debentures: A type of debt instrument that may offer regular interest payments but differs from shares in terms of ownership and risk.
Interesting Facts
- Stability: During economic downturns, investors flock to cumulative preference shares due to their stable return prospects.
- Historical Use: Preference shares were initially used to attract investment in high-risk ventures such as railroads in the 19th century.
Inspirational Stories
- Investor Confidence: A small company in the 1920s issued cumulative preference shares during the Great Depression, which helped retain investor confidence and provided the company with much-needed capital to weather the economic storm.
Famous Quotes
- Peter Lynch: “Cumulative preferred stocks are like savings bonds with a good insurance policy.”
Proverbs and Clichés
- “Slow and steady wins the race”: Reflects the long-term security offered by cumulative preference shares.
- “A bird in the hand is worth two in the bush”: Highlights the reliability of cumulative preference dividends over the uncertain potential of ordinary shares.
Jargon and Slang
- Dividend Arrears: Unpaid dividends that have accumulated over time.
- Preferred Stockholders: Investors who hold preference shares.
FAQs
What happens if a company never makes enough profit to pay the accumulated dividends?
If a company goes bankrupt, cumulative preference shareholders are prioritized in asset distribution after creditors but before ordinary shareholders.
Can cumulative preference shares be converted into ordinary shares?
It depends on the terms set by the issuing company. Some cumulative preference shares may have a convertible option.
Are cumulative preference shares risk-free?
No investment is entirely risk-free, but cumulative preference shares are considered lower risk compared to ordinary shares due to their guaranteed dividend provision.
References
Summary
Cumulative preference shares offer a protective financial mechanism for investors by ensuring that unpaid dividends are eventually paid out before any dividends are distributed to ordinary shareholders. They represent a strategic investment option for those seeking stable returns in fluctuating economic conditions.
By understanding the intricacies of cumulative preference shares, investors can make more informed decisions and potentially safeguard their investments against profit volatility.
