Cumulative Dividend

Many issues of preferred stocks have a cumulative feature, which is a provision through which the company is required to pay any preferred dividends that have not yet been paid completely before this company can pay its dividends to the common stockholders. In other words if the company stops paying dividends to its cumulative preferred stockholders, it will have to pay all what is owed before it can pay common stockholders.

A company that does not fulfill complete payment of dividends is called an arrears, what is defined as having outstanding preferred dividends that have not been paid to a issuance of cumulative preferred stocks.

Before a company could pay dividends to common stockholders it would have to pay dividends in arrears to its cumulative preferred stockholders first. This cumulative feature protects the rights of the preferred stockholders. A preferred issue that does not have a cumulative feature is called a non-cumulative preferred stock. Their dividends do not accumulate if they are not paid.

Convertible feature: Some issues of preferred stocks have a convertible feature that allows the holders to exchange their preferred stock for common shares. Conditions and terms for the conversion are given when the preferred stocks have been recently issued. These terms include a conversion rate which is the number of common shares that preferred stockholders will receive for each preferred share when exchanging and from the price conversion of common stocks.

For example company XYZ issues a new convertible preferred stock that is sold at $100 per share, and that are convertible to 5 common shares of this company. Being the rate of conversion 5:1, and the conversion price $20 per share for the common stock ($100/5 shares). If a common stock has a price in the market of $15, it is not advantageous for the preferred stockholder to convert because the value after conversion is $75 (5 shares at $15). Nevertheless, if the price of common stock boosts to $20 there is parity. Preferred stockholders would not convert because the preferred stocks pay dividends.

If the common stock raises its price above $26 per share , preferred stockholders could benefit from capital appreciation of the common stock when converting in this kind of stock.

The decision to take this option of conversion depends on three factors:

  • The market price of the common stock. It must be greater than the conversion price for the holder to share in capital gains.
  • The amount of the preferred dividend
  • The amount of the common dividend

The conversion figure provides investors the possibility of benefiting from capital gains through common stock appreciation, as well as the relative safety of receiving the preferred dividends from before the conversion.

If the preferred dividend is much higher than that from the common stocks, holders must add this to the appreciation amounts to decide whether to stay with the preferred stocks or convert them in common stocks.