What is Non-Cumulative Preference Shares
The term “non-cumulative preference shares” refers to the variant of preference shares for which the issuing companies are not obligated to pay the stockholders any unpaid or omitted dividends. In other words, in case the issuing company is unable to pay dividends during a particular period due to unforeseeable financial stress, then the holders of non-cumulative preference shares have no right to claim any of the unpaid dividends in the future.
Explanation
Usually, the board of directors of the issuing company have the flexibility to cut or suspend the dividend payment when the company experiences financial distress. Now, unpaid dividends of non-cumulative stockholders will not become arrears in such a scenario, which means that the company will not be liable to pay any of the unpaid dividends to the non-cumulative preference stockholders. Effectively, non-cumulative preference shareholders offer financial flexibility to the companies during times of liquidity stretch.
Features of Non-Cumulative Preference Shares
The features of non-cumulative preference shares are as follows:
- They are issued with pre-determined dividend rates, either as a percentage of the face value or in terms of dollar per share.
- These shareholders are paid their dividends before making the dividend payments to the common shareholders.
- The unpaid dividends of these stockholders are not carried forward to future years.
- The issuing companies can resume making the dividend payments at any time without any regard to the unpaid dividends.
Examples of Non-Cumulative Preference Shares
Following are the examples are given below:
Example #1
Let us take the example of ADF Inc. to illustrate the computation of dividend for non-cumulative preference shares. In 2009, the company issued 10,000 shares of $10 non-cumulative preferred stock and 5,000 shares of $7 cumulative preferred stock. However, due to significant market disruption, the company incurred losses and hence didn’t pay any dividend during the year. In the following year, the company witnessed strong recovery and so the board of directors decided to pay a dividend of $200,000. Determine the dividend paid to the cumulative and non-cumulative preferred stockholders during 2009 and 2010 combined.
During 2009, there will be no arrear for the non-cumulative preferred shareholders. However, an arrear of $35,000 (= $7 * 5,000) will be created for the cumulative preferred shareholders.
During 2010, the non-cumulative preferred shareholders will be paid dividend worth $100,000 (= $10 * 10,000), while the cumulative preferred shareholders will be paid dividendworth $70,000 (= $7 * 5,000 for 2010 and $35,000 arrear from 2009). The remaining $30,000 (= $200,000 – $100,000 – $70,000) dividend will be paid to the common stockholders. Therefore, during these two years the cumulative and non-cumulative preferred stockholders earned dividend of $70,000 and $100,000 respectively.
Example #2
Let us take the example of the above company again. In this case, the company paid a dividend of $160,000 and $180,000 during 2011 and 2012 respectively. Determine the dividend paid to the cumulative and non-cumulative preferred stockholders during 2011 and 2012 combined.
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During 2011, the non-cumulative preferred shareholders will be eligible for dividend of $100,000 (= $10 * 10,000), while the cumulative preferred shareholders will be eligible for dividend of $35,000 (= $7 * 5,000). The remaining $25,000 (= $160,000 – $100,000 – $35,000) dividend will be paid to the common stockholders.
Again in 2012, the non-cumulative preferred shareholders will be paid $100,000 (= $10 * 10,000) as a dividend, while the cumulative preferred shareholders will be paid $35,000 (= $7 * 5,000) in the form of a dividend. In this case, the common stockholders will be paid the remaining $45,000 (= $180,000 – $100,000 – $35,000). Therefore, during these two years, the cumulative and non-cumulative preferred stockholders earned a dividend of $70,000 and $200,000 respectively.
Cumulative vs Non-Cumulative Preference Shares
Some of the major differences between cumulative and non-cumulative preference shares are as follows:
- In case the dividend payment is missed during a particular period, then the unpaid dividend is lost forever for a non-cumulative preference share, while the unpaid portion of the cumulative preference share becomes part of the arrear that may be paid on a future date when funds will be available.
- Cumulative preference shares are paid dividends ahead of non-cumulative preference shares.
- Cumulative preference shares offer a lower dividend rate as compared to non-cumulative preference shares.
- Cumulative preference shares are believed to be less risky than non-cumulative preference shares.
Advantages
Some of the major advantages of non-cumulative preference shares are as follows:
- Since there is no strict obligation to pay a dividend for these stocks, its non-payment doesn’t amount to bankruptcy.
- Unlike interest payment on a debt or divided payment on cumulative preference shares, there is no fixed liability for these stocks.
- These shares are considered part of tangible net worth and as such it helps in improving the capital structure ratio (e.g. debt-to-equity ratio) and in the process enhances the company’s borrowing capacity.
- Issuance of these shares doesn’t dilute control of existing equity shareholders because the holders of the preference shares are not offered voting rights.
- These shares don’t require a charge on assets and so the issuing companies are able to raise the required money while their assets continue to remain free of any charge.
Disadvantages
Some of the major disadvantages of non-cumulative preference shares are as follows:
- Non-cumulative preference shares are one of the costliest sources of funds.
- Although the issuing company doesn’t face any legal implications due to the non-payment of dividends, it may dent the investor’s confidence and impact the company’s image.
- Although the risks of the non-cumulative shareholders are quite similar to that of equity shareholders, but still their pay-out is limited, unlike the equity shareholders.
Conclusion
So, one of the striking feature of non-cumulative preference shares is that there is no liability to pay, which offers flexibility to companies during times of financial crisis. Further, the unpaid dividends also don’t amount to any arrears. As such, companies should include non-cumulative preference shares in their capital structure.
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