 Personal Finance PowerPoint Presentation, Cumulative Preferred Stock, prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia Cumulative Preferred Stock, which you can find online. Take a look at the references, resources, continue your research from there. This by James Chen, updated May 5th, 2022. In prior presentations, we've been taking a look at investment goals, investment strategies, investment tools. Keeping in mind the two major categories of investment, that being fixed income, typically bonds, equities, typically stocks. We're looking at cumulative preferred stock this time. If we just think about the preferred stock in and of itself, that technically is on the equity side of things, but it kind of acts as something that's a little bit in the middle between the fixed income and the equity sides of things. So just a quick recap. When we think of bonds, remember that we're thinking about fixed income generally with it. We can think about that as like us loaning money to the issuer of the bond, that being a corporation or a government typically in return for the fixed income of interest typically as well as the face value at the maturity of the bond. When we're looking at stocks, we're looking at ownership of a corporation, remembering corporations, separate legal entity, stocks representing equal units of ownership. Typically when we're talking about stocks, we're talking about publicly traded corporations, those on an exchange, making it easier for investors to be investing in them. So keeping that in mind, we're now looking at what is cumulative preferred stock. So let's give a quick recap on the preferred stock. The preferred stock is technically on the equity side of things. But it's got kind of characteristics that are in between or characteristics that are similar to a bond side of things. So the preferred means that it's preferred in that you usually get paid before the common stock with regards to the dividends. And it's preferred in that if they were to liquidate the company, go out of business or get bankrupt, then they get paid before the common stockholders, although after typically the bonds, that's kind of why it's kind of like in the middle. So now we're adding the component of the cumulative for the preferred stock. So the cumulative preferred stock is a type of preferred stock with a provision that stipulates that if any dividend payments have been missed in the past, the dividends owed must be paid out to cumulative preferred shareholders first. So when we're thinking about dividends, that's a payout from the corporation to the owners, typically shareholders. We usually think about the common stock with regards to the dividends. Now remember dividends are similar to draws for a sole proprietor. So if I was a sole proprietor, for example, or a partner, I would make money in the business and draw money out from the business for personal use. When we're invested in a corporation, we can't really do that in the same way because the corporate stocks are equal units. So I can't have one owner drawing out more money from one share than another owner. And therefore we have to have the draws in the form of dividends which are elected by the management and the board of directors. So they're going to decide who gets a dividend. That's different than the fixed income where you have bonds, which is kind of like a loan to the company. They have to pay the interest on the bonds. They have no choice unless they go bankrupt or something default. But on the equity, they can decide not to give a dividend. Now they can decide not to give a dividend to the preferred stockholders as well, which are calculated based on the terms of the preferred stock. But if on the terms of the preferred stocks say that it's cumulative, that means that they still owe the preferred stocks the dividends in the future. So it's kind of like getting a hybrid between the bonds and the stocks because they're not required to give out the payment for the dividends to the preferred stock as they are required to give out interest to bonds. But if they don't, then they can't give money to the regular stockholders until they pay the dividends in arrears to once they skipped the ones they decided not to pay. So there that is. So this is before other classes of preferred stock shareholders and common shareholders can receive dividend payments. Cumulative preferred stock is also called cumulative preferred shares. Understanding cumulative preferred stock. Cumulative preferred stock is one type of preferred stock. A preferred stock typically has a fixed dividend yield based on the par value of the stock. This dividend is paid out at set intervals, usually quarterly, to preferred shareholders. Preferred stocks are valued similarly to bonds. So that you have a somewhat fixed payment, you would think in general or under normal circumstances it would be somewhat fixed, even more somewhat fixed than dividends to the common stock shareholders. And therefore it's kind of similar to interest payments in a bond in format then bond proceeds are considered to be a liability while preferred stock proceeds are counted as an asset. Also bondholders have a priority claim on company assets. In other words, if you think of the accounting on the company side of things and you look at their balance sheet, when they issue a bond, they take out a loan. It's recorded on the liability side of things, right? Because they have the bonds payable that they have to pay back to the issuers of the bonds. We own the bonds. So it's an asset to us if we are investing. And the preferred stock proceeds are counted as assets, meaning you don't have that same kind of liability situation with the preferred stock because it's not like a debt instrument, but instead you're getting funding when you issue the preferred stock as the company. And it's an equity interest. And remember the accounting equation is assets equal liabilities plus equity. So assets is what the company has, liabilities and equity are who they owe the money to. If it was a bond, it would be like a third party, like a liability. Equity would be the owner basically owning, owing back in essence to the owner. So mispayments and cumulative preferred stock. When a company runs into financial problems and cannot meet all of its obligations, it may suspend its dividend payments and focus on paying business specific expenses and debt payments. So if it has to, this is a benefit to the company. They can't say, hey, look, we're just not going to pay the preferred stock dividends. That would look bad. They don't really want to do that typically, but they can do that and they cannot do that so easily with a bond because they would default on the contract. They default if it was a bond on the interest, if they didn't pay the interest. So when the company gets through the trouble and starts paying out dividends, again, standard preferred stock shareholders possess no rights to receive any misdividends. So these standard preferred shares are sometimes referred to as non cumulative preferred stock. So if you don't have that stipulation and you are in the preferred stock, you might just lose the dividends in that instance. In contrast, holders of cumulative preferred stock shares will receive all dividend payments in arrears before preferred stockholders receive any payments. So if you have that in place, then you're going to say, well, you can you can do that. They can not pay you there, but they're going to have to pay you before they pay the stockholders. And if they don't pay the stockholders, the people that vote for the board of directors for a long time, they're going to get pissed. So you got to pay back that puts the preferred stockholders in a good position. Essentially, the common stockholders have to wait until cumulative preferred dividends are paid up before they get any dividend payments again. For this reason, cumulative preferred shares often have a lower payment rate than the slightly riskier non cumulative preferred shares. Example of how cumulative preferred stock works. For example, a company issues cumulative preferred stock with a par value of $10,000 in an annual payment rate of 6%. The economy slows down. The company can only afford to pay half the dividend and owes the cumulative preferred shareholder $300 per share. The next year, the economy is even worse and the company can pay no dividends at all. It then owes the shareholder $900 per share. In year three, the economy booms. We're back in business, allowing the company to resume dividends. The cumulative preferred stock shareholders must be paid the $900 in arrears in addition to the current dividend of $600. So notice they were able to not pay the dividends in the past. But now that times are good again, they can't pay the common stockholders who they're trying to make happy because those are the people that vote until they pay the dividends to the preferred first in the ones in arrears, including the ones in arrears. So once all cumulative shareholders receive the $1,500 due per share, the company may consider paying dividends to other classes of shareholders. Risk factor of cumulative preferred stock as the cumulative feature reduces the dividend risk to investors cumulative preferred stock can usually be offered with a lower payment rate than required for a non cumulative preferred stock. Due to this lower cost of capital, most companies prefer stock offerings are issued with the cumulative feature. Generally, only blue chip companies with strong dividend histories can issue non cumulative preferred stock without increasing the cost of capital.