How to pay dividends (mode of paying
dividends)
1. Cash and Bonus issue
2. Stock split and reverse split
3. Stock repurchase
4. Stock rights/rights issue
1. Cash and bonus issue
For a firm to pay cash dividends,
it should have adequate liquid funds.
However, under conditions of
liquidity and financial constraints, a firm can pay stock dividend (Bank issue)
Bonus issue involves issue of
additional shares for free (instead of cash) to existing shareholders in their
shareholding proportion.
Stock dividend/Bonus issue involves
capitalization of retained earnings and does not increase the wealth of
shareholders. This is because R.
Earnings is converted into shares.
Advantages of Bonus Issue
a) Tax advantages
Shareholders can sell new shares,
and generate cash in form of capital gains which is tax exempt unlike cash
dividends which attract 5% withholding tax which is final
b) Indication of high profits in future:
A Bonus issue, in an inefficient
market conveys important information about the future of the company.
It is declared when management
expects increase in earning to offset additional outstanding shares so that
E.P.S is not diluted.
c) Conservation of cash
Bonus issue conserves cash
especially if the firm is in liquidity problems.
d) Increase in future dividends
If a firm follows a fixed/constant
D.P.S policy, then total future dividend would increase due to increase in
number of shares after bonus issue.
Journal entry
in case of bonus issue
Dr. R. Earnings (par value)
Cr. Ordinary share capital (par value)
NB: A firm can also make a script issue where bonus shares are
directly from capital reserve.
2. Stock Split and Reverse Split
This is where a block
of shares is broken down into smaller units (shares) so that the number of
ordinary shares increases and their respective par value decreases at the stock
split factor.
Stock split is meant to make the
shares of a company more affordable by low income investors and increase their
liquidity in the market.
Illustration
ABC Company has 1000 ordinary
shares of Sh.20 par value and a split of 1:4 i.e one stock is split into
4. The par value is divided by 4.
1000 stocks x 4 = 4000 shares
par value = 40 = Sh.5
5
Ordinary share capital = 4000 x 5 =
Shs.20,000
A reverse split is the opposite of
stock split and involves consolidation of shares into bigger units thereby
increasing the par value of the shares.
It is meant to attract high income clientele shareholders. E.g incase of 20,000 shares @ Shs.20 par,
they can be consolidated into 10,000 shares of Shs.40 par. I.e. (20,000 x ½) = 10,000 and Sh.20 = x 2 =
40/=
3. Stock Repurchase
The company can also buy back some
of its outstanding shares instead of paying cash dividends. This is known as stock repurchase and
shares repurchased, (bought back) are called treasury Stock. If some outstanding shares are repurchased,
fewer shares would remain outstanding.
Assuming repurchase does not adversely
affect firm’s earnings, E.P.S. of share would increase. This would result in an increase in M.P.S. so
that capital gain is substituted for dividends.
Advantages of Stock Repurchase
1. It may be seen as a true signal as
repurchase may be motivated by management belief that firm’s shares are
undervalued. This is true in inefficient
markets.
2. Utilization of idle funds
Companies, which have accumulated
cash balances in excess of future investments, might find share reinvestment
scheme a fair method of returning cash to shareholders.
Continuing to carry excess cash may
prompt management to invest unwisely as a means of using excess cash.
Example
A firm may invest surplus cash in
an expensive acquisition, transferring value to another group of shareholders
entirely. There is a tendency for more
mature firms to continue with investment plan even when E (K) is lower than
cost of capital.
3. Enhanced dividends and E.P.S.
Following a stock repurchase, the
number of shares issued would decrease and therefore in normal circumstances
both D.P.S. and E.P.S. would increase in future. However, the increase in E.P.S is a
bookkeeping increase since total earnings remaining constant.
4. Enhanced Share Price
Companies that undertake share
repurchase, experience an increase in market price of the shares. This is partly explained by increase in total
earnings having less and/or market signal effect that shares are under value.
5. Capital structure
A company’s managers may use a
share buy back or requirements, as a means of correcting what they perceive to
be an unbalanced capital structure.
If shares are repurchased from cash
reserves, equity would be reduced and gearing increased (assuming debt exists
in the capital structure).
Alternatively a company may raise debt
to finance a repurchase. Replacing
equity with debt can reduce overall cost of capital due to tax advantage of
debt.
6. Employee incentive schemes
Instead of cancelling all shares
repurchase, a firm can retain some of the shares for employees share option or
profit sharing schemes.
7. Reduced take over threat
A share repurchase reduced number
of share in operation and also number of ‘weak shareholders’ i.e shareholders
with no strong loyalty to company since repurchase would induce them to sell.
This helps to reduce threat of a
hostile takeover as it makes it difficult for predator company to gain
control. (This is referred as a poison
pill) i.e. Co.’s value is reduced because of high repurchase price, huge cash
outflow or borrowing huge long term debt to increase gearing
Disadvantages of stock repurchase
1. High price
A company may find it difficult to
repurchase shares at their current value and price paid may be too high to the
detriment of remaining shareholders.
2. Market Signaling
Despite director’s effort at trying
to convince markets otherwise, a share repurchase may be interpreted as a
signal suggesting that the company lacks suitable investment
opportunities. This may be interpreted
as a sign of management failure.
3. Loss of investment income
The interest that could have been
earned from investment of surplus cash is lost.
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