Preferred DividendDefined with Formula and Explanation
What is a Preferred Dividend?
There are two distributive types of dividends – Common and Preferred Dividends.
Common dividends are from common/ordinary shares while preferred dividends are from preferred shares that have the characteristics of fixed annual dividend percentage.
These types of shareholders are prioritized when it comes to receiving dividends over common shareholders.
Preferred Dividends Formula
The formula to compute Preferred Dividends is:
Preferred Dividends = par value x rate of dividends x no. of Preferred Shares
There are two factors to consider when investing in preferred shares:
- Par value per share
- Rate of dividends
Once these factors are present, an investor may calculate their expected annual preferred dividend income.
The good thing about preferred stocks is that they are considered a secured investment because of the yearly assured fixed dividend payments.
In the event of dividend distribution, they are the company’s top priority to be paid first over equity shareholders.
In the same way, in the event of bankruptcy, the preferred shareholders are to be paid next after the settlement of all company’s debts.
Example of Preferred Dividend
Chuck Walker wishes to invest preferred shares in Carmichael Corporation.
The investment agreement contains the following information:
Par Value: $150
Dividend Rate: 7%
Preferred Stock Acquisition: 5,000 Preferred Shares
Chuck’s yearly dividend income is:
= $150 * 7% x 5,000
Common Features of Preferred Dividends
Higher Dividend Rate
Preferred Shares have a higher equity percentage distribution than common shares.
They are given a higher dividend percentage rate because preference shareholders do not have any ownership and voting power, unlike common shareholders.
All companies do this practice to entice more potential preference shareholders.
Whatever the company’s profit margin percentage for the current period, the preferred dividend percentage will remain the same.
Preferred shareholders will still receive the same dividend rate every year.
Common stockholders rely on the residual amount of net income after the deduction of all expenses, tax payable, and preferred dividends.
At every annual general meeting, shareholders get to recommend the dividend percentage of common shareholders.
Shareholders’ decisions rely heavily on the financial performance of the company during a given year.
Because of this, the common shareholders dividend percentage tends to fluctuate when different factors are considered.
Cumulative or Arrears in Dividend
Preferred Shareholders are indeed entitled to a fixed dividend rate every year.
However, there are situations when a company is not able to declare and distribute dividends due to other financial demands the company must address.
When this happens, the dividend due will carry forward to the subsequent year for payment.
To illustrate further, As of December 31, 2021, Big Mike Ltd. has an 8%, 1,500,000 Preferred Shares Outstanding, with a par value of $8 per share.
The available cash balance of the company is $500,000.
The Preferred Dividend for the year 2021 is:
= ($8 * 8% ) * 1,500,000
Since the available cash balance is lower than the computed preferred dividends, Big Mike Ltd. will not distribute any dividends for the year 2021.
Instead, it will be carried forward to the next year’s payments.
The company’s legal obligation is to prioritize the declaration and distribution of preferred dividends.
Under no circumstances should the Preferred Shareholders not receive any dividend amount due to them, even those in arrears.
The distribution agreement is absolute and unconditional.
Any violation or a breach of contract corresponds to a penalty or fine, and could even lead to the director’s imprisonment.
Preferred Shareholders have the advantage of receiving dividend income first before any distribution is made to common shareholders or any other equity-related distributions.
When a company is liquidated, preferred shareholders are to be paid next after settling all company’s debt obligations.
Aside from the mentioned features above, there are other Preferred Shares features used in the corporate world.
Uses of Preferred Dividends
The different features of Preferred Dividend are:
- It has a fixed dividend percentage.
- Undeclared and undistributed dividends for the previous year/s will be accounted for as dividends in arrears and will be distributed once the company can do so. Its special feature is its ability to receive dividends in arrears. This applies to cumulative preferred stock only.
- For non-cumulative preferred stock, they don’t enjoy such right.
Preferred Dividend Calculation in Excel
- Higher dividend rate – Preference shares have a greater advantage than all debt instruments like Government Treasury Bills, Bonds, Commercial papers, etc. A Preference Shareholder may achieve a higher dividend rate with direct return on equity distribution and is given the right to receive dividend payments first. The higher the invested amount, the higher the return.
- Preferential Treatment – Preferred Shareholders have the advantage of receiving the dividends first than common shareholders. In the liquidation process, the preferred dividend is to be paid next after settling all company’s debts.
- Assured minimum return – since preferred shares have a fixed dividend rate feature, investors have the assurance to receive a minimum return of payment of their investment based on the agreed percentage. Whatever the economic situation, whether the company earns a profit or not, preferred shareholders will still receive dividends based on the agreement.
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