1.         Income Disposal Option

When a company earns income through its regular operations or other activities, it can make use of the same for one of the following:

a.  Reinvestment

b.  Distribution to shareholders

c.  Acquisition of securities

d.  Paying off debt

This gives rise to another important question. What should be the appropriate dividend policy?

2.         Dividend Policy

The dividend policy of a corporation should cover the following three important issues:

1.  The fraction of earnings that can be distributed

2.   Whether distribution should be in cash or through stock repurchase

3.   The level of dividend growth that needs to be maintained

3.         Methods of Paying Dividends

3.1.     Cash Dividends

a.  These are dividends paid in cash.

b.  Paid on per share basis.

c.  It may be paid out of retained earnings

d.  Cash dividends may be of two types: Regular Dividends & Dividend Reinvestment Plan

3.4.1. Regular Dividends

a.  These are recurring dividends paid on a quarterly, semi-annually, and annual basis, generally.

b.  Investors usually prefer a stable and predictable dividend policy. A stable policy means dividends paid at a steady rate.

c.  Stable policy indicates that:

     i.  Company is growing

    ii.  Company is willing to share gains with investors

   iii.  Management’s confidence in the future of the company.

d.  This may, however, also indicate a sign of lack of sufficient growth opportunities.

3.4.2. Dividend Reinvestment Plans (DRIPs)

a.  It is a program run by the company for its shareholders

b.  Instead of paying cash dividends to the shareholders, the amount of dividend is reinvested by the company on the behalf of its shareholders.

c.  This is done by purchasing additional shares (or fractional shares) on the behalf of the shareholder.

d.  DRIP has the following advantages to the companies:

     i.  It provides a stable base of shareholders, who can eventually help to stabilize the share price of the company. These are the shareholders who are interested in long-term buy-and-hold strategy instead of those frequently moving in and out of stocks with short-term investment goals.

    ii.  This helps to keep the capital inside the company, by not having to frequently pay the same to the shareholders.

   iii.  Helps in raising additional capital without making an additional offer.

e.  For the investors, the main advantage of DRIPs is that the investors are saved from paying additional fees and commissions for additional investments. Moreover, some companies also provide discounts on such investments

f.  The main disadvantages of DRIPs for the shareholders are:

     i.  The investors are supposed to keep extra scrupulous records about the date of acquisition, its costs, etc. in order to be able to determine the cost of acquisition at the time of sale of shares.

    ii.  The dividend that is reinvested is also treated as the ordinary income, and subject to the same income-tax treatment in most of the jurisdictions. So, the investors have to pay taxes, whether they have received the cash or not.

3.2.     Extra or Special Dividends

a.  It is a non-recurring dividend generally paid in cash.

b.  These are mainly paid by the companies in cyclical industries.

c.  These are generally paid after exceptionally strong profits earned by the companies.

d.  These are also tools for financial restructuring such as the spin-off of a subsidiary company to the shareholders.

3.3.     Liquidating Dividends

a.  It is a payment made from capital rather than earnings.

b.  These dividends are paid when the firm usually dissolves its business, or sells a part of the business for cash, and distributes its proceeds for cash.

c.  Such distribution is treated as capital gains for tax purposes.

4.         Stock Split and Stock Dividends

4.1.     Stock Split

a.  Sometimes the shares become so expensive that shareholders cannot afford to buy them even in the range of 100 sets. In such a situation, the companies opt to split the shares into a smaller denomination.

b.  Thus, a stock split is a method of dividing the shares into a smaller denomination. For example, a 2 for 1 split would make the shareholder entitled to two shares for each share held by them. In this case, every shareholder would get one additional share.

c.  The management of a corporation generally opts for a stock split if they see the positive signal and there is a need for boosting the stock price. They do this only when they think that the price is high, and the future of the corporation is bright.

d.  Usually the reduction of the price at the time of split is in proportion to the increase in the number of shares.

4.2.     Stock Dividend

a.  In the case of a stock dividend, instead of cash, additional shares are issued to the shareholders.

b.  The stock dividends are generally issued as a percentage. For example, a 50% stock dividend would mean the issue of one share for every two shares held by the shareholders.

c.  A regular stock dividend generally keeps the price of the stocks constrained. However, smaller stock dividends increase the need for paperwork and are more expensive.

4.3.     Benefits of Stock Splits & Stock Dividends

a.  There is no loss of cash in issuing the dividends.

b.  It broadens the base of shareholders for the company by issuing more shares.

c.  The stocks with lower stock prices attract more investors.

d.  The shareholders have a choice either to sell the shares obtained as a result of a split or dividend and cash them out. Or else, they can keep them as investments and keep them for growth.

e.  The main benefit of a stock split is that the shareholders do not have to pay the taxes on the value obtained.

f.  As noted, there is generally an increase in the price of the share after the announcement of a stock split or dividend. This is mainly because of positive signals of favorable prospects of the companies. This increase continues before they finally fall back to normal after some time.

5.         Difference Between Cash Dividends and Stock Splits & Dividends

6.         Reverse Stock Split

a.  A reverse stock split reduces the number of shares and increases the share price proportionately.

For example, if you own 1,000 shares in a company and the company announces a reverse stock split of 1 in 5 then you will own 200 shares in the company.