Preferred stock is an important funding source for the issuing corporation and a relatively safe investment alternative to common stock for the investor. Regardless of whether it is cumulative or non-cumulative, all types of preferred shares enjoy priority over common stock. Only after preferred stockholders have been paid in full can common shareholders receive any money. In addition, cumulative preferred stock provides additional advantages over and above the non-cumulative type.
Both in terms of its income potential as well as risk, preferred stock lies somewhere between common stock and bonds. Preferred stock promises the investor a fixed annual payment, usually expressed as a percentage of its face, also known as par, value. No matter how profitable the issuing firm, the holder can never receive more than this fixed sum. These shares are preferred in the sense that common shareholders cannot receive a dividend until all preferred stockholders have been paid in full. However, banks and bondholders have priority over preferred stockholders and must be paid in full before preferred stockholders are paid.
If the firm lacks the funds to pay preferred shareholders, its board of directors can suspend dividend payments indefinitely. This is a relatively drastic measure and would send a chilling message to all stakeholders. It obviously means that common shareholders will receive nothing, and chances are the firm will not be able to invest in new technologies or services to stay competitive in the marketplace. Most companies will choose to meet all payment obligations before investing in innovation. What will happen once the company recovers and resumes preferred dividends depends on whether the preferred shares are cumulative or non-cumulative.
If the preferred shares are cumulative, all past suspended payments must be made in full before common stockholders can receive anything at all. Assume, for example, that there are 1 million preferred shares, each carrying a 6 percent coupon and $1,000 face value, therefore entitled to $60 per year. In 2011, the firm is able to pay only $30 per preferred stock, and the next year it suspends all preferred dividends. Therefore, the firm owes preferred stockholders $30+$60 = $90 in back payments. For 1 million shares, this amounts to $90 million, all of which must be paid before common stockholders can receive any dividends at all.
If the preferred stock is non-cumulative, the issuing company can resume preferred dividend payments at any time, with disregard to past, missed payments. If the preferred stock in our example is non-cumulative, the preferred stockholder will never get the missed $90 per share. Just as important, the common shareholders must not wait for the firm to accumulate a whopping $90 million and pay all past claims before they can receive their share of the firm's profits.
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