Cumulative dividend

Cumulative dividend is a feature of preferred stock that requires any unpaid dividends to accumulate and be paid before common shareholders receive any distributions. When a company suspends dividend payments, holders of cumulative preferred stock retain their right to eventually receive all missed payments^[1]. This feature makes cumulative preferred stock more attractive to investors seeking income stability and positions it between bonds and common stock in the capital structure hierarchy.

Definition and mechanism

Cumulative preferred stock carries a fixed dividend rate established when shares are issued. If the corporation cannot or chooses not to pay dividends in a given period, the obligation does not disappear. Instead, unpaid dividends accumulate as "dividends in arrears."

Before distributing any dividends to common shareholders, the company must first pay all accumulated dividends to cumulative preferred shareholders. This priority ensures that preferred investors eventually receive their expected income, even after periods of financial difficulty.

The accumulation continues indefinitely until payment. A company experiencing five years of dividend suspension would owe cumulative preferred shareholders five years of accumulated dividends before common shareholders could receive anything.

Calculation formula

The cumulative dividend calculation follows a straightforward formula:

Cumulative Dividend = Dividend Rate x Par Value

Consider shares with a 7% dividend rate and $1,000 par value. The annual cumulative dividend equals $70 per share (0.07 x $1,000). If dividends are suspended for three years, total arrears reach $210 per share^[2].

An investor holding 1,000 preferred shares with 5% dividend rate and $100 par value would receive $5,000 annually ($5 per share x 1,000 shares). After two years without payment, the company would owe this investor $10,000 in accumulated dividends.

Comparison with non-cumulative preferred stock

Non-cumulative preferred stock (also called "straight preferred") lacks the accumulation feature. If a company skips a dividend payment on non-cumulative shares, shareholders lose that payment permanently. They cannot recover it in future years.

This difference significantly affects investor rights. Non-cumulative shareholders face greater income uncertainty. A company struggling financially for several years might pay no dividends during that period, and non-cumulative shareholders would receive nothing for those years even after recovery.

Because cumulative features protect investors, companies can typically issue cumulative preferred stock with lower dividend rates than straight preferred stock. Investors accept lower yields in exchange for the security of eventual payment^[3].

Accounting treatment

Dividends in arrears do not appear as liabilities on the balance sheet. Until the board of directors formally declares a dividend, no legal obligation exists. The company has not promised to pay; it has merely promised to pay preferred shareholders first when payments resume.

Companies must disclose accumulated arrears either on the balance sheet or in footnotes to financial statements. This disclosure alerts investors and analysts to potential claims on future cash flows. Large arrears may affect perceptions of common stock value.

When arrears are finally paid, the payment reduces retained earnings just as regular dividends would. The accumulated obligation does not accrue interest, so the eventual payment equals simply the sum of missed dividends.

Investor considerations

Cumulative preferred stock appeals to income-focused investors who want more stability than common stock provides. The fixed dividend rate and cumulation feature create predictable income streams under normal circumstances.

Risk does not disappear entirely. Companies in severe financial distress may file for bankruptcy, potentially wiping out preferred shareholders entirely. Cumulative features protect against temporary difficulties, not permanent insolvency.

Preferred stock typically does not appreciate significantly in value. Unlike common stock, preferred shareholders usually do not benefit from company growth beyond their fixed dividend. This makes preferred stock unsuitable for growth-oriented investors.

Corporate perspective

Companies issue cumulative preferred stock to raise capital without diluting common shareholder voting rights. Preferred shareholders typically cannot vote on corporate matters except in specific circumstances such as prolonged dividend non-payment.

The cumulative feature increases the cost of equity capital compared to non-cumulative preferred. Companies must weigh the lower dividend rates achievable against the potential burden of accumulated arrears during difficult periods.

Some venture capital term sheets specify cumulative dividends on preferred shares. This ensures early investors receive returns even if exit timing is delayed. The accumulation protects investor interests during extended holding periods.

Historical context

Preferred stock originated in the nineteenth century as railroads and industrial companies sought alternatives to debt financing. The cumulative feature developed as investors demanded stronger protections for their capital.

During the Great Depression, many companies suspended dividends for extended periods. Cumulative preferred shareholders accumulated large arrears that companies eventually paid when profitability returned. This historical experience demonstrated the practical value of cumulative features.

Modern preferred stock continues evolving. Features like participation rights, conversion options, and redemption provisions layer onto basic cumulative structures, creating hybrid securities tailored to specific investor and issuer needs.

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References

• Brealey, R.A., Myers, S.C. & Allen, F. (2020). Principles of Corporate Finance. 13th ed. McGraw-Hill.
• Graham, B. & Dodd, D.L. (2009). Security Analysis. 6th ed. McGraw-Hill.
• Kieso, D.E., Weygandt, J.J. & Warfield, T.D. (2019). Intermediate Accounting. 17th ed. Wiley.
• Ross, S.A., Westerfield, R.W. & Jordan, B.D. (2019). Fundamentals of Corporate Finance. 12th ed. McGraw-Hill.

Footnotes

<references> <ref name="fn1">[1] Cumulative preferred stock requires unpaid dividends to accumulate as "dividends in arrears"</ref> <ref name="fn2">[2] Calculation: Dividend Rate x Par Value = Annual Dividend; multiply by years unpaid for total arrears</ref> <ref name="fn3">[3] Cumulative preferred can be issued at lower dividend rates than non-cumulative due to reduced investor risk</ref> </references>