Cumulative preferred stock is a form of equity issued by a company. Holders of this class of stock are entitled to receive a dividend before a payout is made to common shareholders. If a company does not declare any dividend in a year, cumulative preferred stockholders will be entitled to receive arrears of dividend before a payment is made to common stockholders.
What does Cumulative Preferred Stock mean?
Stockholders of this category enjoy special privileges. If a company declares a dividend, they have priority over other shareholders for payment.
Even if a company misses payments for several years, the cumulative preferred stockholder is entitled to a dividend before any distribution is made to those holding a company’s common stock. In fact, the cumulative preferred stockholder must be paid all arrears of dividend before common stockholders are paid.
There is another advantage that cumulative preferred stockholders enjoy. In the event of the liquidation of the company, this category of stockholder must be paid before any sum is paid on account of common shares.
Example of cumulative preferred stock
A firm issues 8% cumulative preferred stock of a total value of $100 million. The shareholders who subscribe to the issue are entitled to $8 million in dividends every year. In the first three years, the dividend is regularly paid.
However, the company runs into financial difficulties and suspends all dividend payments for the next three years. In year seven, profitability improves, and dividend payments are resumed. As payment has not been made on account of the cumulative preferred stock, a sum of $32 million must be paid to shareholders who own this stock before any payout to the common stockholders.
This dividend payment on account of the cumulative preferred stock can be summarized in the following manner:
⇨ Year 1: $8 million paid.
⇨ Year 2: $8 million paid.
⇨ Year 3: $8 million paid.
⇨ Year 4: Dividend not paid.
⇨ Year 5: Dividend not paid.
⇨ Year 6: Dividend not paid.
⇨ Year 7: $32 million paid ($8 million each for years 4,5, and 6 and $8 million for year 7)
Cumulative preferred stockholders are guaranteed a dividend payment, including payment of arrears, before a payout is made to common shareholders.