Cumulative Preferred Stock
Cumulative preferred stock (also called cumulative preference shares) is a class of preferred stock whose dividends accumulate if they are not paid in any year and must be paid in future before any dividends are paid to common stockholders.
Preferred dividends must be paid before any dividends are paid to common shareholders. If in any year, there is not enough net income to pay off any dividends, the dividends due on preferred stock for the year must be carried forward and the accumulated balance must be paid in future years when net income is positive and only then can any dividends on common stock can be declared.
Your company has 10 million outstanding preferred stock with a par value of $10 each carrying a dividend rate of 6% and 20 million outstanding common stock with par value of $15.
The preferred stock is cumulative.
If net income for the 2015, 2016 and 2017 were $4.5 million, $8.5 million and $10 million. Find out preferred dividends paid in each year and the amount, if any, available for distribution to common stockholders.
Dividends on the cumulative preferred stock must be paid out before any dividends are paid to common shareholders. The annual preferred dividend obligation is $6,000,000:
= 10,000,000 × $10 × 6%
$4,500,000 of the $6,000,000 dividends due on cumulative preferred stock can be paid out from net income in 2015 and $1,500,000 are carried forward. No dividends can be paid to common stockholders in 2015.
In 2016, dividends due on cumulative preferred stock amount to $7,500,000 (i.e. $6,000,000 due related to 2016 and $1,500,000 carried forward from 2015). The difference i.e. $1,000,000 can be paid out to common stockholders in 2016.
In 2017, the whole $6,000,000 dividends due on cumulative preferred stock can be paid and the differential i.e. $4,000,000 is available for distribution to common stockholders.
However, it is not mandatory to pay any common dividends in 2016 and 2017.