In addition to issuing equity shares to the public, a company is also authorized to issue a different type of shares to the public to raise capital for its operations. These shares are what finance experts call ‘preference shares.’ Unlike regular equity shares, preference shareholders don’t hold any ownership in the company and so they don’t enjoy any voting rights.
Preference shares are more akin to debt and feature different subtypes as well. One of the most popular types of preference shares is cumulative preference shares. If the question ‘what are cumulative preference shares?’ is running on your mind right now, here’s everything that you should know.
What are cumulative preference shares?
Cumulative preference shares contain all the features and benefits of ordinary preference shares such as entitlement to higher dividend payouts, preference in payment of dividends, and preference in payment over equity shares during the liquidation of the company.
In short, cumulative preference shares are regular preference shares with one additional benefit. The extra advantage here is that the holders of these shares have the right to receive dividends even if the issuing company has missed out on paying them in the past.
Sometimes, companies might not be able to generate profits due to a number of reasons. This lack of profits may force them to not pay any dividends for a certain period of time or pay only a reduced portion of the profits as dividends. Even under such a situation, cumulative preference shareholders retain the right to receive dividends unlike equity shareholders.
If you still haven’t gotten a clear understanding of the concept, here’s a cumulative preference shares example to better drive the point home.
Cumulative preference shares – an example
For instance, let’s assume that there’s a company named ABC Ltd. that’s issued cumulative preference shares of a face value of Rs. 100 per share to the public. The company promises to pay 10% of the share’s face value as dividends every quarter of a financial year.
In keeping with the promise, the company has been paying a dividend of Rs. 10 per share regularly for every quarter of a financial year. But suddenly, due to a slump in the market conditions, the company couldn’t generate enough revenue and as a result went into a loss. Under such a situation, the company failed to pay dividends to its shareholders including cumulative preference shareholders for 3 quarters of a financial year.
The company started generating revenue only in the final quarter of the financial year and as such has enough revenue to pay dividends as per its promise to its preference shareholders. Here’s where things get interesting. Since the holders of cumulative preference shares are entitled to receive dividends regularly, including past dividends that were missed, the company would have to first clear all the unpaid dividends (i.e. the dividend arrears of Rs. 30 per share), before getting to pay the dividend for this quarter of Rs. 10 per share.
Once the company has paid out all of the arrears, it shall then pay the current quarter’s dividends to cumulative preference shareholders, provided that there are enough profits. After clearing all of the dues, only then the company shall pay dividends to its equity shareholders.
Types of Cumulative Preference Shares
Cumulative preference shares come in various subtypes, each offering unique features and benefits. Here are some common types:
- Convertible Cumulative Preference Shares:
- These shares can be converted into a specified number of equity shares after a predetermined period or under certain conditions. This provides the shareholders with the potential for capital appreciation.
- Non-Convertible Cumulative Preference Shares:
- These shares cannot be converted into equity shares. Investors benefit solely from dividend payouts and the preferential treatment during liquidation.
- Redeemable Cumulative Preference Shares:
- The issuing company can redeem (buy back) these shares after a certain period. This gives companies flexibility in managing their capital structure.
- Irredeemable Cumulative Preference Shares:
- These shares do not have a maturity date, meaning they remain outstanding indefinitely unless the company decides to buy them back.
- Participating Cumulative Preference Shares:
- In addition to the fixed dividend, holders of these shares may receive additional dividends if the company achieves certain financial goals or profits exceed a specified threshold.
- Non-Participating Cumulative Preference Shares:
- These shares only entitle the holder to the fixed dividend and do not provide any additional dividend participation.
Advantages of cumulative preference shares
Now that you’ve seen the cumulative preference shares example, let’s move onto the various advantages that these shares offer to both the investors as well as the issuing company. Here’s a brief glimpse at some of the benefits that come with these shares.
1. Investors get to enjoy a higher rate of dividend when compared with equity shareholders.
2. Cumulative preference shares get preference over equity shares with respect to dividend payouts as well as claims during liquidation.
3. Cumulative preference shares don’t lose out on the dividends if the company fails to pay them. The unpaid dividends keep accumulating till the company finally decides to pay them out.
Disadvantages of Cumulative Preference Shares
While cumulative preference shares offer several benefits, they also come with certain drawbacks:
- Fixed Dividend Rate:
- The dividend rate is fixed and does not increase with the company’s profitability, potentially resulting in lower returns compared to equity shares during high-profit periods.
- No Voting Rights:
- Shareholders do not have voting rights, limiting their influence over company decisions and governance.
- Dividend Payment Obligation:
- The accumulation of unpaid dividends can strain the company’s finances, especially if the company faces prolonged financial difficulties.
- Potential Dilution:
- For convertible cumulative preference shares, converting these into equity can dilute the ownership of existing equity shareholders.
- Limited Capital Appreciation:
- Preference shares generally do not appreciate in value as much as equity shares, limiting potential capital gains for investors.
Conclusion
Cumulative preference shares are a great way for companies to secure funding for their operations. Not only does issuing these shares give companies some flexibility, but it also doesn’t dilute the ownership or control. That said, here’s something that you should note. The dividend rate for cumulative preference shares is usually slightly lower than that of regular preference shares due to the unpaid dividends getting accumulated instead of lapsing.
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FAQs
Difference between cumulative and non-cumulative preference shares?
Cumulative preference shares accumulate unpaid dividends, prioritising their payment over equity shareholders. Non-cumulative preference shares do not accumulate dividends; missed dividends are lost.
How are cumulative preference shares taxed?
Dividends from cumulative preference shares are generally taxed as dividend income, subject to varying tax laws based on the investor’s country.
Can companies skip dividend payments on cumulative preference shares?
Companies can skip dividend payments on cumulative preference shares in unprofitable periods. However, unpaid dividends accumulate and must be settled before paying equity shareholders in profitable periods.
Are there guaranteed returns with cumulative preference shares?
No, returns on cumulative preference shares are not guaranteed as they depend on the company’s profitability, especially during financial difficulties.
