Dividends

When a company pays dividends to its shareholders, it is giving them a portion of its earnings. The amount that is paid to each shareholder is dependent on the number of shares that they own. Indeed, the payout and is guided by the company’s payout policy. Usually, when a company intends to make a dividend payment, its board of directors will make a declaration after gaining the requisite approval from shareholders.

A company can distribute its profits to shareholders as dividends in several ways. These include: (i) cash dividends in the form of either regular, extra (irregular) or liquidating dividends; (ii) stock dividend; (iii) stock splits; and (iv) reverse stock splits.

Regular Cash Dividends

A company pays regular cash dividends whenever it distributes a share of its profits in the form of cash to its shareholders on the basis of a regular dividend payment schedule. For example, the company may opt to pay shareholders a dividend every quarter, semiannually, or even on an annual basis.

When a company consistently pays regular cash dividends over a long period of time, it sends a positive signal to the financial markets, indicating that it is growing and should continue to grow and pay dividends in future.

Companies tend to maintain or increase their cash dividend payments so as to build shareholder confidence and positively impact share price.

Dividend Reinvestment Plan

A Dividend Reinvestment Plan (DRIP) allows a shareholder to reinvest a portion or the whole of their cash dividends in the company. This increases the amount of their shares in the company. There are three forms of DRIP, which are differentiated by the source of shares for dividend reinvestment:

• Open Market DRIPS: in these DRIPs, a company purchases shares in the open market for distribution to shareholders;
• New Issue DRIPS: in these DRIPS, rather than purchase shares, a company issues additional shares; and
• Plans that are allowed to obtain shares either through open-market purchases or new share issuance.

Extra or Special (Irregular) Dividends

Extra dividends, also referred to as special or irregular dividends, are dividends that are paid by a company in a manner that does not follow a routine payment schedule . These dividends supplement regular cash dividends with an extra payment.

Many companies choose to use special dividends as a means of distributing more earnings to shareholders in good economic times.

Liquidating Dividends

Liquidating dividends are paid by a company when:

• the company goes out of business and decides to distribute its net assets; or
• the company sells a portion of its business for cash and distributes the proceeds; or
• the company pays dividends which are in excess of its accumulated retained earnings.

Stock Dividends

Stock dividends refer to all dividend payments that are not in the form of cash. In these instances, a company chooses to distribute profits in the form of additional shares as opposed to using cash.

When a company pays stock dividends, the total number of outstanding shares will increase, accompanied by a decrease in the earnings per share. As a result, a shareholder’s proportionate ownership in the company will remain the same. Likewise, their total cost basis will be unchanged since they did not purchase the additional shares. Rather, the shares were “given” to them. Their cost per share will, however, be reduced.

Primary Difference Between Cash and Stock Dividends

Payment of cash dividends alters a company’s capital structure, whereas payment of stock dividends does not.

A company’s assets and shareholder’s equity both decrease whenever a cash dividend is paid. On the other hand, when a stock dividend is paid, a company’s assets and shareholder’s equity remain the same.

Cash dividends tend to lead to higher financial leverage ratios and lower liquidity ratios, while stock dividends, and stock splits, have no such impact on a company.

Stock Splits

In a stock split, a company gives its shareholders X number of shares for every Y number of shares that are owned, where X>=Y. For example, in a two-for-one stock split, shareholders receive one additional share for every share previously owned.

A stock split neither changes shareholders’ wealth nor the market value of a company. Although the number of outstanding shares increases, the earnings per share and price per share decrease while the Price/Earnings or P/E ratio remains the same. Likewise, each shareholder’s total cost basis does not change since they did not purchase the additional shares.

If after a stock split, a company does not vary its dividend payout ratio i.e. dividends paid or net income available for the year, then its dividend yield i.e. annual dividend per share or price per share, will also remain the same.

A company usually announces a stock split when it believes that its share price is too high and it wants to reduce it to a lower level which is more marketable so as to encourage more investments in its shares.

Reverse Stock Splits

A reverse stock split is the opposite of a stock split. In a reverse stock split, a company reduces the number of outstanding shares by a set multiple. For example, if a company announces a 1-for-4 reverse stock split, this means that shareholders will receive 1 share for every 4 shares that they own.

A reverse stock split results in an increase in the price per share but has no effect on a company’s market value or shareholders’ total cost basis.

A company usually announces a reverse stock split when it believes that its share price is too low and it wants to increase it to a level which is more marketable so as to encourage more investments in its shares.

Question

Which of the following statements is accurate?

A. A company’s share price decreases in a reverse stock split

B. Total shareholders’ wealth increases after a stock dividend is paid

C. A company’s share price decreases after a stock split

Solution

The correct answer is C.

A stock split decreases a company’s share price to a marketable range.

A is incorrect because a reverse stock split results in an increase, not a decrease in share price. B is incorrect because a stock dividend does not change total shareholders’ wealth.

Reading 38 LOS 38a:

Describe regular cash dividends, extra dividends, liquidating dividends, stock dividends, stock splits, and reverse stock splits, including their expected effect on shareholders’ wealth and a company’s financial ratios