Deborah teaches college Accounting and has a master's degree in Educational Technology and holds certifications as a CIA, CISA, CFSA, and CPA, CA.
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.
Advantages of Cumulative Preferred Stock
The main advantage of owning cumulative preferred stock is the ability to accumulate company dividends and know the company will pay at a future date. If Chelsea purchases cumulative preferred stock, she knows that Harry's Hardware Hut will pay its outstanding dividends when it has a profitable year.
Chelsea also has a greater claim on the assets or items of value that Harry's Hardware Hut owns in the event that Harry goes out of business. Chelsea would also receive a higher rate of return or the percentage amount of gain on her investment if she purchases a cumulative preferred stock as Harry would have to compensate her for the possibility that she would not receive regular dividend payments.
Chelsea now has a much better understanding of preferred shares, including the features and benefits of cumulative preferred stock.
Investors can purchase common stock or ownership in a company that entitles them to vote for the company's board of directors and receive dividends or a distribution of company profit in years when the company makes money. Investors could also purchase preferred stock in a company. Preferred stock does not have voting rights.
Preferred stock can be cumulative preferred stock, where an investor is entitled to the current year's dividends, as well as all dividends in arrears, or outstanding dividends from previous years, or non-cumulative preferred stock, where a company does not pay dividends in arrears. If a company cannot pay dividends, then owners of non-cumulative preferred stock would receive any dividend for the year.
Owners of preferred stock have a higher claim on the assets of a business or items of value that it owns than common shareholders do. Preferred shareholders also earn a higher rate of return or the percentage gain on their investment as the company must compensate them for the possibility that they will not receive regular dividend payments.
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