Dividends on preferred stock
In the absence of specification 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 thereby 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 and must be paid in total before any dividends are paid to common stockholders. Because 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. Further, the fact that the company was unable to pay a dividend may indicate the existence of a serious cash flow problem that could affect 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, the 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 participating preferred stock was fairly common early in the 1900s, its use currently is generally confined 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.
First, the preferred stockholders receive up to the regular maximum before the common stockholders receive any cash. Second, the common stockholders receive up to their regular maximum before the preferred stockholders receive any additional amounts. Third, the two classes share any amounts above the second threshold in proportion to their total par values. Fourth, 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 this capital structure of Sample Company:
Several situations can be considered.
1. Preferred stock is not cumulative or participating; total dividend is $175,000:
2. Preferred stock is cumulative but not participating; $100,000 of dividends are in arrears; total dividend is $175,000:
3. Preferred stock is participating but not cumulative; total dividend is $50,000:
4. Same as 3 above; total dividend is $125,000:
The second threshold of $200,000, not reached. or 5 percent of total par value, was not reached.
5. Same as 3 above; 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, three fourths to common).
6. The preferred stock is cumulative and participating; $65,000 of dividends are in arrears; total dividend is $281,000:
The participation rate of .4 percent was found by dividing the excess over the second threshold ($16,000) by the total par value ($4,000,000).