INTRODUCTION: Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be paid to the shareholders as a dividend. Many corporations retain a portion of their earnings and pay the remainder as a dividend.
For a joint stock company, a dividend is allocated as a fixed amount per share. Therefore, a shareholder receives a dividend in proportion to their shareholding. For the joint stock company, paying dividends is not an expense; rather, it is the division of an asset among shareholders. Public companies usually pay dividends on a fixed schedule, but may declare a dividend at any time, sometimes called a special dividend to distinguish it from a regular one.
Cooperatives, on the other hand, allocate dividends according to members’ activity, so their dividends are often considered to be a pre-tax expense.
Dividends are usually settled on a cash basis, store credits (common among retail consumers’ cooperatives) and shares in the company (either newly-created shares or existing shares bought in the market.) Further, many public companies offer dividend reinvestment plans, which automatically use the cash dividend to purchase additional shares for the shareholder.
Several factors must be considered when establishing a firm’s dividend policy. These include
- The liquidity position of the firm – just because a firm has income doesn’t mean that it has any cash to pay dividends.
- Need to repay debt – oftentimes there are negative covenants that restrict the dividends that can be paid as long as the debt is outstanding.
- The rate of asset expansion – the greater the rate of expansion of the firm, the greater the need to retain earnings to finance the expansion.
- Control of the firm – if dividends are paid out today, equity may have to be sold in the future causing a dilution of ownership.
Technically, it is illegal to pay a dividend except out of retained earnings. This is to prevent firms from liquidating themselves out from underneath the creditors.
Internal Revenue Service Section 531 – Improper Accumulation of funds. This is to prevent individuals from not paying dividends in order to avoid the personal income taxes on the dividend payments.
Is it in the best interests of shareholders to pay out earnings as dividends or to reinvest them in the company? The answer to this depends upon the investment opportunities that the firm has.
There are three fundamental policies to paying cash dividends that firms employ:
- Pay a constant dollar amount each year regardless of earnings per share. This is what most firms do.
- Use a constant payout ratio (for example, 50% of EPS)
- Pay a low, fixed dividend amount plus “dividend extras” or “special dividends”. This allows the company to avoid having to cut dividends since the basic dividend is low, but also avoids the improper accumulation of funds during good years.
A cut in dividends generally hurts a stock’s price because it sends a signal to stockholders that management’s outlook for the future is that the company cannot continue to pay the dividend. Most companies therefore start off with a low dividend and only increase it when they feel that the earnings prospects have improved sufficiently to allow for maintaining a higher dividend. Many companies will even borrow money in a bad year in order to avoid cutting the dividends.
The market price is influenced by dividends through what is called the “clientele” effect. That is, some investors want dividends (such as retirees and pension funds) while others do not want dividends (wealthy individuals) but would prefer capital gains (which are taxed at a lower rate and deferred).
Flotation costs encourage a company to retain earnings in order to minimize having to sell additional stock in the future. As we saw in the cost of capital calculations, the flotation costs make new equity more expensive than retained earnings.
Some companies pay no dividends. Why? Because they have good investment opportunities and reinvest the earnings.
Forms of Payment
Cash dividends (most common) are those paid out in the form of a cheque. Such dividends are a form of investment income and are usually taxable to the recipient in the year they are paid. This is the most common method of sharing corporate profits with the shareholders of the company. For each share owned, a declared amount of money is distributed. Thus, if a person owns 100 shares and the cash dividend is $0.50 per share, the person will be issued a cheque for $50.
Stock or scrip dividends are those paid out in form of additional stock shares of the issuing corporation, or other corporation (such as its subsidiary corporation). They are usually issued in proportion to shares owned (for example, for every 100 shares of stock owned, 5% stock dividend will yield 5 extra shares). If this payment involves the issue of new shares, this is very similar to a stock split in that it increases the total number of shares while lowering the price of each share and does not change the market capitalization or the total value of the shares held.
Property dividends or dividends in specie (Latin for “in kind”) are those paid out in the form of assets from the issuing corporation or another corporation, such as a subsidiary corporation. They are relatively rare and most frequently are securities of other companies owned by the issuer, however they can take other forms, such as products and services.
Other dividends can be used in structured finance. Financial assets with a known market value can be distributed as dividends; warrants are sometimes distributed in this way. For large companies with subsidiaries, dividends can take the form of shares in a subsidiary company. A common technique for “spinning off” a company from its parent is to distribute shares in the new company to the old company’s shareholders. The new shares can then be traded independently.