Cumulative Preference Shares- Meaning Features and Benefits
When learning about valuation of shares, it is important to understand how different types of preference shares work. Cumulative preference shares give investors a special right to receive unpaid preference dividends in future periods. If a company cannot pay the dividend in one year, the unpaid amount usually carries forward until the company pays it. Preference shares already provide shareholders with priority over ordinary shareholders for dividends and, depending on the terms, claims on assets during liquidation. The cumulative feature gives investors additional protection because missed dividends do not simply disappear.
What Are Cumulative Preference Shares?
Cumulative preference shares are preference shares that allow unpaid dividends to accumulate for future payment. The company normally must clear these accumulated dividends before it can distribute dividends to ordinary shareholders. For example, assume a company issues preference shares with a fixed annual dividend of Rs. 10 per share. If the company cannot pay the dividend for two years, the shareholder can have Rs. 20 in unpaid dividends per share.
This feature makes cumulative preference shares different from non-cumulative preference shares. With non-cumulative shares, an unpaid dividend for a particular period generally does not carry forward.
How Cumulative Preference Shares Work
The basic process is easy to understand. A company sets a dividend rate when it issues the preference shares, and the shareholder receives the stated dividend when the company pays it according to the share terms.
If the company skips a payment, the unpaid dividend becomes a dividend in arrears. The amount remains associated with the cumulative preference shares and can become payable when the company later makes the required distribution.
The following example shows how the accumulation works:
| Year | Dividend Due Per Share | Dividend Paid | Dividend in Arrears |
|---|---|---|---|
| Year 1 | Rs. 10 | Rs. 0 | Rs. 10 |
| Year 2 | Rs. 10 | Rs. 0 | Rs. 20 |
| Year 3 | Rs. 10 | Rs. 30 | Rs. 0 |
Example of Cumulative Preference Shares
Consider ABC Limited, which issues 5,000 preference shares with a face value of Rs. 100 each. The shares carry a cumulative dividend rate of 8% per year.
The annual dividend per share is:
Rs. 100 × 8% = Rs. 8
For 5,000 shares, the annual preference dividend becomes:
5,000 × Rs. 8 = Rs. 40,000
Suppose ABC Limited cannot pay the dividend in the first year. The Rs. 40,000 becomes dividend in arrears. If the company also misses the second year’s payment, another Rs. 40,000 accumulates.
By the beginning of the third year, the company has Rs. 80,000 of unpaid preference dividends, before considering the third year’s dividend. If the company later pays the required dividends, it must deal with the accumulated amount according to the terms of the shares and applicable law.
Cumulative Preference Shares vs Non-Cumulative Preference Share
| Feature | Cumulative Preference Shares | Non-Cumulative Preference Shares |
|---|---|---|
| Missed dividend | Usually carries forward | Usually does not carry forward |
| Dividend arrears | Accumulate | Generally do not accumulate |
| Investor protection | Higher for missed dividends | Lower for missed dividends |
| Priority over ordinary shares | Usually applies | Usually applies when dividends are paid |
| Income recovery | Past eligible dividends can be recovered | Missed dividends are generally lost |
Why Companies Issue Cumulative Preference Shares
Companies use different forms of preference shares to raise capital while offering investors specific rights. A cumulative feature can make an issue more attractive because investors receive greater protection against missed dividends. Preferred shares can also combine equity and debt-like characteristics. They represent ownership, but they often provide a fixed dividend and priority over ordinary shareholders for distributions.
For a company, issuing preference shares can provide another way to raise funds without using ordinary shares alone. However, the exact rights depend on the issue terms, company law, and the market where the shares are issued.
Benefits of Cumulative Preference Shares
One major benefit is protection against missed dividends. If the company skips a dividend because of financial pressure, the cumulative feature normally allows the unpaid amount to remain claimable in future periods. Another benefit is priority over ordinary shareholders for dividends. The company generally cannot pay dividends to ordinary shareholders while required cumulative preference dividends remain unpaid, subject to the specific terms and applicable law.
Cumulative preference shares can therefore appeal to investors who want a more predictable income structure than ordinary shares normally provide. However, investors should still examine the company’s financial position because a cumulative right does not mean immediate cash payment when the company lacks funds.
Limitations of Cumulative Preference Shares
The cumulative feature offers protection, but it does not remove investment risk. A company may face financial problems for several years, causing dividend arrears to grow while shareholders wait for payment. Investors also need to understand that preference shares often provide less potential upside than ordinary shares. Ordinary shareholders can benefit more when company profits and share prices rise strongly, while preference shareholders often receive a stated dividend instead.
The exact rights also vary between issues. Some preference shares may be convertible, callable, participating, or redeemable, so investors should read the terms before making an investment decision.
Cumulative Preference Shares and Dividends in Arrears
The phrase dividend in arrears describes an unpaid dividend that has become due. In cumulative preference shares, these unpaid amounts can build up over several periods until the company settles them. For example, assume a shareholder should receive Rs. 6 per share each year. If the company misses the payment for three years, the accumulated amount becomes Rs. 18 per share, before adding any amount due for the current year.
The company’s financial statements may also provide information about dividends in arrears. Investors can use this information to understand whether a preference share issue has accumulated unpaid distributions.
Cumulative Preference Shares and EPS
Cumulative preference shares also matter when a company calculates earnings per share (EPS). EPS measures the earnings attributable to each ordinary share, so preference dividends must be considered before calculating earnings available to ordinary shareholders. For cumulative preference shares, the current period’s preference dividend entitlement is deducted from earnings available to common shareholders even if the company has not declared or paid that dividend. However, dividends from previous periods that remain in arrears are not added again to the current EPS deduction.
This rule helps prevent ordinary shareholders from appearing to receive more earnings than they actually have available after considering the preference shareholders’ current entitlement.
Are Cumulative Preference Shares a Good Investment?
Cumulative preference shares may suit investors who value a stated dividend and greater protection against missed preference dividends. They can provide a middle ground between ordinary shares and some fixed-income investments because they have features associated with both equity and debt.
However, investors should consider the company’s financial strength, dividend history, share terms, market price, interest-rate conditions, and redemption features. A cumulative dividend does not guarantee that an investor will receive cash immediately, especially when the company faces financial difficulty.
Key Features at a Glance
| Feature | Explanation |
|---|---|
| Share type | Preference share |
| Dividend | Usually fixed or stated in the issue terms |
| Unpaid dividend | Usually accumulates |
| Dividend arrears | Can build up over multiple periods |
| Ordinary shareholder priority | Preference dividends generally come first |
| EPS treatment | Current cumulative preference dividend is deducted |
| Main advantage | Greater protection against missed dividends |
| Main risk | Payment can still be delayed when the company faces financial problems |
Conclusion
Cumulative preference shares give investors a right to accumulate unpaid preference dividends for future payment. This feature makes them different from non-cumulative preference shares, where a missed dividend generally does not carry forward.
The most important concept is simple: if a cumulative preference dividend is not paid, the unpaid amount can accumulate as arrears. When the company later makes the required distribution, those arrears generally receive priority according to the share terms before ordinary shareholders receive dividends. For students, remember the formula and the concept together. If the face value is Rs. 100 and the dividend rate is 8%, the annual dividend is Rs. 8 per share, and any unpaid eligible amount can accumulate in later years.
