Cumulative preference share
A preference share whose unpaid dividend is not lost: it is carried forward to later years and paid when there are profits, if the terms of issue allow.
In plain language
A preference share pays a pre-defined rate of dividend, and that dividend comes before any dividend to equity shareholders. But it is still a dividend, not interest: the workbook is clear that preference shareholders are paid only if the company has sufficient profits.
So what happens in a year with no profits? For an ordinary preference share, that year's dividend is simply not paid.
A cumulative preference share changes that. The workbook: "The unpaid dividend may be carried forward to the following year(s) and paid if there are profits to pay the dividends, if the terms of issue of the shares so allow. Such shares are called cumulative preference shares."
The missed dividend is postponed, not cancelled.
How it works
What a preference share is, per Chapter 2. A special kind of equity share with features of both equity and debt:
| Resembles debt | Differs from debt |
|---|---|
| Pre-determined rate of dividend | Holder is a shareholder, not a creditor |
| Not secured — it is not a borrowing | |
| Dividend is paid from residual profits after tax, whereas debenture interest is an expense before tax |
Preference shares carry no voting rights and no right over the company's assets like common equity, but they have preference over ordinary equity in dividend and in return of capital on winding up.
The cumulative feature adds a memory. Each year's fixed dividend that cannot be paid is carried forward and paid in a later year when profits permit. Whether a share is cumulative depends on its terms of issue.
What does not change. Returns come only from dividends. The shares are usually not listed and there is not much scope for capital appreciation, because they do not participate in the company's profits beyond the fixed rate — their value is not affected by the company over- or under-performing.
The formula
Annual preference dividend = Dividend rate × Face value × Number of shares
Dividend payable in year t (cumulative) = Current year's dividend + Arrears carried forward
A worked example
Illustrative terms. Kaveri Foods has 1,00,000 preference shares of Rs 100 face value carrying an 8 per cent dividend.
Annual preference dividend = 8% × Rs 100 × 1,00,000 = Rs 8,00,000
Profits over three years:
| Year | Profits available? | Cumulative share: paid | Arrears carried | Non-cumulative share: paid |
|---|---|---|---|---|
| 1 | No | Nil | Rs 8,00,000 | Nil — lost |
| 2 | No | Nil | Rs 16,00,000 | Nil — lost |
| 3 | Yes | Rs 24,00,000 | Nil | Rs 8,00,000 |
A holder of 500 cumulative shares receives nothing for two years, then Rs 12,000 in year 3 (500 × Rs 8 × 3). A holder of 500 non-cumulative shares receives Rs 4,000 in year 3 and never sees the other Rs 8,000.
In this illustration the terms of issue provide for the arrears to be paid before any equity dividend — consistent with the preference share's priority over ordinary equity in the payment of dividend.
Why NISM asks about it
Chapter 2 (Securities: Types, Features and Concepts of Asset Allocation and Investing), section 2.3.2 "Types of Equity Capital", defines the cumulative preference share straight after listing how preference shares differ from debentures. Expect a definition question ("preference shares on which unpaid dividends are carried forward are called...?"), and statements testing the qualifiers: paid only if there are profits, and only if the terms of issue allow.
Common exam traps
- Cumulative ≠ guaranteed. Arrears are paid only if there are profits; a company that never recovers never pays them.
- "If the terms of issue so allow." The carry-forward is a term of the share, not an automatic right of every preference share.
- Preference dividend is not interest. It is paid from profits after tax; debenture interest is an expense before tax.
- Preference shareholders are shareholders, not creditors, and the shares are unsecured.
- No voting rights and little capital appreciation — the workbook notes they are usually unlisted and unaffected by the company's over- or under-performance.
- Preference over equity, behind lenders, in both dividend and return of capital.
Where this is taught
Free preparation for NISM Series XXI-BRelated terms
- Equity sharesOwnership in a company entitling holders to a share in profits and a vote on its affairs; equity holders are residual owners after all contractual claims, rewarded by dividend and capital appreciation.
- Final dividendA dividend declared at the AGM, taxable in the shareholder's hands in the year it is declared — unlike an interim dividend, which is taxed only in the year it is actually made available to the shareholder.
- Preference shareA share carrying a pre-defined rate of dividend, paid before any equity dividend, with priority over equity in return of capital on winding up — but normally no voting rights.
- Convertible preference shareA preference share that gives its holder the right to convert it into a fixed number of equity shares, turning a fixed, dividend-paying instrument into ordinary equity ownership.
- Residual claimThe equity shareholder's place at the back of the queue: entitled only to profits and assets left after government, lenders, employees and preference shareholders have been paid.
- DebentureIn Indian usage, a long-term debt instrument issued by a company, bank or financial institution — as opposed to a bond, the term reserved for debt issued by a government or its undertakings.