This section deals with the policies that firms employ when distributing the income to shareholders.
Dividend policy involves three issues:
Firms can pay dividends in a number of ways.
A cash dividend is the type most people are familiar with. It is a cash amount, usually paid on a per share basis. It is paid out of retained earnings.
These are dividends distributed by companies on a regular recurring basis, usually quarterly, semi-annually, or annually.
Both evidence and logic suggest that investors prefer companies that follow a stable, predictable dividend policy. The "stable dividend policy" generally means increasing the dividend at a reasonably steady rate. It signals to investors that:
However, some investors interpret rising dividends as a tacit sign of lack of sufficient growth opportunities.
A DRIP is a program run by a company for its shareholders. Instead of sending dividend checks to shareholders enrolled in a company's DRIP, the company reinvests those dividends by purchasing additional shares (or fractional shares) in the shareholder's name.
Companies like DRIPs for several reasons.
For shareholders, the best part about DRIPs is that most DRIPs allow additional purchases to be made without a fee or commission. Some companies even offer the additional benefit of purchasing shares at a discount (usually 3-5%) to the market price.
Disadvantages for shareholders:
An extra dividend is a non-recurring distribution of company assets, usually in the form of cash, to shareholders.
A liquidating dividend is a payment by a firm to shareholders from capital rather than from earnings. This isn't really a good thing. It usually occurs when a company dissolves its business or sells part of its business for cash, and distributes the proceeds to its shareholders. The distribution would be treated as a capital gain for tax purposes.
Stock Splits and Stock Dividends
There is a belief that there is an optimal price range for every share. This is the price for the share when the price/earnings ratio and hence the company's value is maximized. Consider a share that has become so costly that investors cannot afford to buy the share in the required even lot of 100 shares. To correct this situation the company would split its stock.
A stock split divides each outstanding share into several shares. In a 2-for-1 stock split, the holder of 1 share will get an additional share. This increases the number of shares outstanding and is generally used after a sharp price run-up to produce a large price reduction. Normally, splits reduce the price per share in proportion to the increase in shares; splits merely "divide the pie into smaller slices." However, firms generally split their stocks only if the price is quite high and management thinks the future is bright. Therefore, stock splits are often taken as positive signals and thus boost stock prices.
A stock dividend is a dividend paid in additional shares of stock rather than in cash. Stock dividends are expressed in percentages. For example, on a 100% stock dividend, a holder of 1 share will get an additional 1 share. Stock dividends used on a regular basis will keep stock prices more or less constrained. However, small stock dividends create bookkeeping problems and unnecessary expenses.
Both stock splits and dividends are used to keep stock prices within an "optimal" trading range. Stock splits or dividends are just more pieces of paper: they both divide the pie into smaller slices without affecting the fundamental position of the current stockholders. Each shareholder will own more shares, but each share is worth less; his or her slice of the firm's pie remains the same.
The benefits of a stock split or dividend for a company:
Differences between cash dividends and stock splits or dividends:
For a shareholder, the benefit of a stock split or dividend is choice. The shareholder can either keep the shares and hopes that the company will be able to use the money not paid out in a cash dividend to earn a better rate of return than the investor could with the cash dividend or the shareholder could sell some of the new shares to create their own cash dividend. The biggest benefit of a stock split or dividend is that shareholders do not generally have to pay taxes on its value.
Taxes do need to be paid if a stock dividend has a cash-dividend option, even if the shares are kept instead of the cash.
The price of a stock typically rises shortly after the announcement of a stock dividend or split. However, the price increase is the result of positive signals of favorable prospects for earnings and dividends, not a desire for stock splits or dividends per se. Without good earnings or dividends news in the next few months, the stock price will fall back to the earlier level.
A reverse stock split reduces the number of shares and increases the share price proportionately. For example, if you own 10,000 shares of a company and it declares a one for ten reverse split, you will own a total of 1,000 shares after the split. A reverse stock split has no affect on the value of what shareholders own.
Companies often reverse split their stock when they believe its price is too low to attract investors. It's usually a bad sign if a company is forced to reverse split. Companies do it to make their stock look more valuable, but in reality nothing changes. A company may also do a reverse split to avoid being de-listed.
A. Special dividends
I. is a stock split.
A. cash dividends; coupon payments
Each dollar of a firm's after-tax earnings has two (and only two) outlets which are retained earnings and cash dividends.
A. Price per share will fall by half.
A. transfer from retained earnings to equity capital
At the start of trading on the ex-distribution date, there will be three times as many shares outstanding as at the close of the previous day. Assuming no significant change in the total share value, the share price should be $60/3 = $20.
At the start of trading on the ex-distribution date, there will be 20% more shares outstanding as at the close of the previous day. Assuming no significant change in the total share value, the share price should be $50/1.2 = $41.67.
A. higher; higher
A cash dividend would decrease stockholders' equity, increasing the debt/equity ratio. It would also reduce cash, decreasing the current ratio.
A. unchanged; lower
A stock dividend would leave both of these ratios unchanged.
I. A stock dividend should decrease share price, other things being equal.
A. I only
A stock split will reduce the price and earnings per share proportionately, leaving the price-to-earnings ratio the same.
A. Sell 20 shares
The total cash flow from a $5/share dividend would be $10,000 for you. Selling shares at $100/share, you would need to sell 100 shares to generate a $10,000 cash flow.
A. greater wealth if the company paid a special cash dividend.
I. stock splits
A. I and IV
Stock splits have no effect on retained earnings. They are simply a redistribution of the same equity of a company with a different number of outstanding shares.
A. 200 shares of ABC and 200 shares of DEF
The 3 for 1 split multiplies holdings by 3, and the 50% stock dividend multiplies holdings by 1.5.