In the absence of specifications otherwise, holders of preferred stock are entitled to receive dividends in any given year only up to a stated maximum. If they fail to receive the maximum, common stockholders receive no dividends at all.
In order to make the preferred shares more marketable and, in this way, to lower the dividend rate, many firms issue cumulative preferred stock.
Under the terms of this arrangement, any amounts of preferred dividends not declared in a given year are carried forward into the future. They must be paid in total before any dividends are paid to common stockholders.
Since these dividends in arrears have not been declared payable by the directors, they do not constitute a liability. However, they do constitute a significant limitation on the potential cash flows to investors.
Furthermore, the fact that the company is unable to pay a dividend may signal serious cash flow problems, which could have implications for creditors. For these reasons, the existence of dividends in arrears should be clearly disclosed.
As an additional feature, some preferred stocks may be participative. That is to say, preferred stockholders can receive more than the stated dividend if the dividend on the common stock exceeds a specified amount.
This arrangement increases the possibility of a higher payoff and generally allows the stated preferred dividend rate to be set lower than otherwise.
Although the use of participating preferred stock was fairly common early in the twentieth century, its use is currently confined usually to closely held companies.
When preferred stock is fully participating, there are in effect three thresholds that are passed through as the total dividend increases:
- The preferred stockholders receive up to the regular maximum before the common stockholders receive any cash
- The common stockholders receive up to their regular maximum before the preferred stockholders receive any additional amounts
- The two classes share any amounts above the second threshold in proportion to their total par values
- If the second threshold is defined in terms of a percentage of par value (usually the same as the preferred dividend rate), the par value of the common stock becomes quite significant
To demonstrate these features, assume that Sample Company has the following capital structure:
Several situations can be considered regarding the issuance of dividends on preferred stock.
1. Preferred stock is not cumulative or participating; the total dividend is $175,000:
2. Preferred stock is cumulative but not participating; $100,000 of dividends are in arrears; the total dividend is $175,000:
3. Preferred stock is participating but not cumulative; the total dividend is $50,000:
4. Same as 3 above; the total dividend is $125,000:
The second threshold of $200,00 (or 5% of total par value) was not reached.
5. Same as 3 above; the total dividend is $240,000:
In this case, the second threshold was exceeded and the excess was shared on the basis of total par values (one-fourth to preferred stockholders, three-fourths to common stockholders).
6. The preferred stock is cumulative and participating; $65,000 of dividends are in arrears; the total dividend is $281,000:
The participation rate of 0.4% was found by dividing the excess over the second threshold ($16,000) by the total par value ($4,000,000).