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Cumulative Preferred Stock: Definition & Advantage

Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology and holds certifications as a CIA, CISA, CFSA, and CPA, CA.

When you invest in a company, you could choose to buy common stock or preferred stock. In this lesson, you will learn about cumulative preferred stock.

Common Stock vs. Preferred Stock

Let's meet Chelsea, who recently inherited a small amount of money from her grandmother. A friend told her about a profitable local company, Harry's Hardware Hut, that has cumulative preferred stock. Chelsea doesn't know much about investing and isn't sure what this type of stock is and what its advantages might be for her. Let's see if we can help Chelsea with this problem.

When you buy an ownership interest in a company, you can purchase common stock or preferred stock. If Chelsea were to buy common stock in Harry's Hardware Hut, she could vote for the company's board of directors, and she could receive dividends or a distribution of the company's profits in proportion to the number of shares that she owns, although the company is not obligated to make dividend payments on a regular basis. If the company were to go bankrupt, she would be at the bottom of the list to recover any portion of her investment.

If Chelsea were to buy preferred stock, she would not have the ability to vote for the board of directors since preferred stock does not have voting rights, but she would be higher up the list to recover a portion of her investment if the company were to go bankrupt. Chelsea would also have the right to receive dividends on a regular basis, and she would receive these dividends before the company pays any dividends to common stock owners.

What Is Cumulative Preferred Stock?

There are two types of preferred stock: cumulative and non-cumulative. A company with cumulative preferred stock must pay all outstanding dividends or dividends in arrears before it can pay any dividends to owners of common stock. If a company is unable to pay its preferred dividends in a given year, they are carried forward into future years until the company has enough profit to pay them.

Let's assume that Harry's Hardware Hut has common stock and cumulative preferred stock, and it has $20,000 available to pay dividends this year. Harry's Hardware Hut has 10,000 cumulative preferred shares, and its dividend rate is $1.50 per share. Since Harry's must pay its cumulative preferred dividends first, it would pay its preferred shareholders $15,000 (10,000 shares x $1.50 per share), which would leave $5,000 ($20,000 - $15,000) for common shareholders.

Let's assume the situation was different, and Harry's Hardware Hut had a difficult year and was unable to pay the dividend to its 10,000 preferred shareholders, including Chelsea. It would carry the $15,000 dividend in arrears forward to a future year when it had the money to pay the outstanding dividends.

Let's assume that Harry was able to turn his business around, and he made a profit the following year and declared a dividend of $40,000. Harry would have to pay Chelsea and the rest of his preferred shareholders the dividends in arrears first before it could pay any dividends to the common shareholders. Therefore, Harry would pay $30,000 to his preferred shareholders ($15,000 from the previous year in arrears + $15,000 from the current year), which would leave $10,000 ($40,000 - $15,000 - $15,000) available to pay his common shareholders.

What Is Non-Cumulative Preferred Stock?

Non-cumulative preferred stock still doesn't have voting rights attached to it, but owners of this type of preferred stock would lose any dividend that the company was unable to pay in a particular year. Let's assume that Harry's Hardware Hut had non-cumulative preferred stock consisting of 10,000 shares with a dividend rate of $1.50 per share. Every year, Harry's preferred shareholders should receive $15,000 (10,000 shares x $1.50 per share), but if Harry doesn't have the money to pay the dividend, owners such as Chelsea would receive no dividend and the company would not carry the outstanding amount forward to a future year. Chelsea and the other shareholders would lose the dividend.

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