Question

What is the difference between cumulative preferred stock and noncumulative preferred stock? Give examples and advantages/disadvantages of each.

Answer 1

Solution:

    Difference between cumulative and non-cumulative preferred stock.

  

Basis of Difference	Cumulative Preferred Stock	Non Cumulative Preferred Stock
Arrear Dividend	Arrear dividend gets accumulated and right to get paid in subsequent years.	No such rights.
Dividend rate	Lower than non cumulative preferred stocks.	Higher than cumulative preferred stocks.
Order of Payment	Paid before non cumulative preferred stocks.	Paid after cumulative preferred stocks.
Credit rating	It gives higher credit rating to the company.	Lower credit rating to the company.

Cumulative Preferred Stock:

Cumulative preferred stock is a division of Preferred stock (shares). It gives the right to shareholders to receive any dividend payments that have been missed/omitted in the previous years before any dividend is paid out to other classes of preferred stock holders and equity shareholders.

In short, Cumulative Preferred stock holders have preference over other stock holders in respect of dividend payouts.

Example:

A company issues Cumulative preferred stock with a par value of $6,000 with payment rate at 6% per annum. Company faces serious business disruptions at end of year 1, hence unable to pay full dividend and decided to pay half the dividend. In such case company owes $180($360/2) as dividend to cumulative preferred stock holders, which will be accumulated and paid in subsequent years. At end of year 2 the company shall pay $540 ($360+$180) to Cumulative preferred stock holders first. Once full payment is made to cumulative preferred stock holders, company can pay to other classes of share holders.

Advantages:

To Companies:

1. It provided flexibility for dividend payment.

2. Helps in financial leverage.

3. It is cheaper than Equity shares.

4. Provides higher credit rating to the company.

To Investors:

1. It is secured investment,

2. It provides higher rate of return and can act as much stable income than equity stockholders.

3. It gives preference in case of Insolvency which is a advantage to investors.

Disadvantages:

To Companies:

1. It comes with fixed obligation like interest payment in case of debt.

2. It is costly compared to debt finance.

To Investors:

1. No Voting rights

2. Ranked lower to debt instruments.

3.Lower dividend rates as compared to non-cumulative preferred stocks.

Non-Cumulative Preferred Stock:

Non-cumulative preferred stock is another division of Preferred stock, where shareholders hold no right to claim any dividend in subsequent years. Company has no obligation to pay dividends of earlier years to this class of stock holders.

In short, company can skip paying the dividend without accumulating any balance for subsequent years.

Example:

A company issues Cumulative preferred stock with a par value of $6,000 with payment rate at 6% per annum. Company faces serious disruptions at end of year 1, hence unable to pay any dividend. In this case dividend of $360($6000*6%) will not be accumulated or carry forward.

Advantages:

1. Companies has No obligation to pay, that is company can skip the dividend payout without creating any accumulation.

2. It gives flexibility to companies as fixed obligation gets reduced, resulting in better management of funds.

3. It gives preference in case of Insolvency which is a advantage to investors.

4. Preference over common stockholders..

Disadvantages:

1. Ranked below Cumulative preference stockholders in case of dividend payouts.

2. No voting rights.

3. It provides lower credit rating to company.