Cumulative Preferred Stock

Cumulative Preferred Stock
See also
Callable Preferred Stock Mezzanine capital Shareholder loan Contributed Surplus Capital dividend Sinkable bond Bonds in finance Redeemable shares Tax preference theory

Cumulative Preferred Stock is „preferred stock on which all dividends must be paid before the common stock receives any dividend. These dividends on a cumulative preferred stock must be paid even for years in which the corporation did not earn an adequate profit to pay the stated dividend” (J.D. Ashcroft, J. Ashcroft 2001, s. 414).

Cumulative Preferred Stock is more widespread than non-preferred shares. If the person collecting the dividend has accumulated preference shares and does not receive the dividend due, the issuer is still owed that dividend. If the issuer announces a joint dividend, it must first make all outstanding payments to cumulative senior shareholders (S.M. Rice 2007, s. 68).

The most preferred type of share is the one whereby persons with dividend rights do not have voting rights. Sometimes, however, the holder of cumulative preferred stock may be entitled to vote if the company whose shares it holds is late with several dividend payments (The Securities Institute of America Inc. 2015, s. 15).

Preferred Stock

Preferred stock „is a hybrid - it is similar to bonds in some respects and to common stock in other ways. Accountants classify preferred stock as equity, hence show it on the balance sheet as an equity account. However, from a finance perspective preferred stock lies somewhere between debt and common equity -it imposes a fixed charge and thus increases the firm's financial leverage, yet omit ting the preferred dividend does not force a company into bankruptcy. Also, unlike interest on debt, preferred dividends are not deductible by the issuing corporation, so a preferred stock has a higher cost of capital than debt. We first describe the basic features of preferred, after which we discuss the types of preferred stock and the advantages and disadvantages of preferred stock” (E. Brigham, M. Ehrhardt 2008, s. 743). There are a few various types of Preferred Stock (E. Brigham, M. Ehrhardt 2008, s. 743):

• Basic Features,
• Adjustable-Rate Preferred Stock (ARPs),
• Cumulative Preferred Stock,
• Market Auction Preferred Stock.

Advantages and Disadvantages of Preferred Stock

Advantages (E. Brigham, M. Ehrhardt 2011, s. 764):

1. Unlike bonds, the obligation to pay a privileged dividend is not certain, and the transfer (not paying) of a privileged dividend cannot force a company to go bankrupt;
2. By issuing preference shares, the company avoids dilution of ordinary capital that occurs when ordinary shares are sold;
3. Because preferred shares sometimes have no maturity, and because preferred fund withdrawals (if present) are usually spread over a long period, preferred issues reduce the drainage of cash flow from principal repayment that occurs with debt issuance.

Disadvantages (E. Brigham, M. Ehrhardt 2011, s. 764):

1. Dividends from preferred shares are usually not deductible from the issuer, so the preferred cost after tax is usually higher than the cost of debt after tax. However, the tax advantage favored by corporate buyers reduces pre-tax costs, and thus effective cost;
2. Although the preferred dividends can be transferred, investors expect their payments and companies intend to pay them if the conditions allow. Therefore, preferred dividends are considered a fixed cost. As a result, their use as debt increases the financial risk and thus the cost of shared capital.

Examples of Cumulative Preferred Stock

• One example of cumulative preferred stock is the 4.25% Cumulative Preferred Stock, Series A, of the Bank of Montreal. This stock was issued in November 2017 and ranks equally with all other classes of the bank’s preferred shares. The dividend on this stock is payable quarterly and accumulates if not paid.
• Another example of cumulative preferred stock is the 5.50% Non-Cumulative Preferred Stock, Series A, of the Canadian Imperial Bank of Commerce. This stock was issued in October 2017 and is also equal in rank with all other classes of the bank's preferred shares. The dividend on this stock is also payable quarterly, but does not accumulate if not paid.
• A third example of cumulative preferred stock is the 4.25% Cumulative Preferred Stock, Series B, of the Bank of Nova Scotia. This stock was issued in December 2017 and has the same ranking as the other classes of the bank’s preferred shares. The dividend on this stock is payable quarterly and accumulates if not paid.

Other approaches related to Cumulative Preferred Stock

The following are some of the other approaches related to Cumulative Preferred Stock:

• Participating Preferred Stock - This type of stock allows holders to receive an additional dividend if the company's earnings rise above a certain level.
• Convertible Preferred Stock - This type of stock allows holders to convert their preferred shares into common shares at a predetermined rate.
• Callable Preferred Stock - This type of stock allows companies to buy back the preferred stock at predetermined prices.
• Adjustable Preferred Stock - This type of stock allows companies to adjust the dividend on the stock over time.

In summary, there are several other approaches related to Cumulative Preferred Stock that can be used to provide different benefits to different shareholders. These approaches include Participating Preferred Stock, Convertible Preferred Stock, Callable Preferred Stock, and Adjustable Preferred Stock.

References

• Ashcroft J.D., Ashcroft J. (2001), Cengage Advantage Books: Law for Business, South-Western Cengage Learning, Mason, s. 414
• Brigham E., Ehrhardt M. (2008), Financial Management: Theory & Practice: 12th Edition, Thomson South-Western, Mason, s. 743
• Brigham E., Ehrhardt M. (2011), Financial Management: Theory & Practice: 13th Edition, South-Western Cengage Learning, Mason, s. 764-765
• Rice S.M. (2007), Series 7 Exam For Dummies, Wiley Publishing Inc., Hoboken, s. 68
• The Securities Institute of America Inc. (2015), Wiley Series 65 Exam Review 2015 + Test Bank: The Uniform Investment Adviser Law Examination, John Wiley & Sons Inc., Hoboken, s. 15

Author: Agnieszka Damian