The most common reason for issuing scrip dividends is to keep the cash reserves. However, companies also have other valid reasons to issue scrip dividends instead of cash dividends.
Let us discuss what are scrip dividends and why do companies issue them.
What is a Scrip Dividend?
A scrip dividend is paid in the form of stocks or shares to the shareholders of a company.
Scrip dividends are calculated and issued in a proportionate way of the existing shares for all shareholders. It means the shareholders would receive scrip dividends in the same proportion as their existing shareholding in the company.
Often companies issue dividends in the form of cash. However, for cash shortage and several other reasons, a company may decide to issue dividends in the form of stocks rather than cash.
A scrip dividend is different from a scrip issue or bonus issue where a company issues bonus shares as dividends to its existing shareholders.
How Does Scrip Dividend Work?
Some companies issue cash dividends outright and do not offer alternatives to their shareholders.
Others can offer scrip dividends with or without the choice to shareholders.
Sometimes, a company will issue scrip dividends that offer shareholders a choice to either receive cash dividends or new shares.
Some companies may also issue new shares as dividends without offering an alternative to the shareholders.
Once a company announces the dividend policy, it will decide the issuance method. As a well-known fact, issuing dividends is not an obligation for the companies but a choice.
After issuing dividends, a company may impose restrictions on selling the newly issued shares. This period is termed the holding period of newly issued shares.
The purpose of the holding period is to avoid share price volatility and achieve stability.
How Scrip Dividend is Calculated?
Although a company issues new shares when announcing scrip dividends, it will declare the total dividend amount in dollar terms.
Shareholders will then need to calculate their new number of shares with respect to the reference share price.
The reference share price is often an average share price of the company a few days before the ex-dividend date.
Suppose a company ABC has 1 million outstanding shares with a market share price of $ 21. It announces a scrip dividend of $ 10 million. Therefore, the dividend per share will be $ 10.
The average share price or the reference share price for ABC company is $ 20. Assume an investor holds 500 shares of the ABC Company.
The scrip dividend for the investor can be calculated by the formula:
Scrip Dividend = Number of Shares Held at Record Date × Cash Dividend per Share / Reference Price of Share
Scrip Dividend = (500 × 10)/20 = 250
It means an investor will receive one new share against every two shares held previously.
Why Do Companies Issue Scrip Dividends?
As mentioned earlier, companies have no obligation of paying dividends at all. They can also pay dividends in the form of cash.
So, why do companies issue scrip dividends then?
Let us explore a few key reasons here.
1. To Control Share Prices
A scrip dividend program or a scrip issue means issuing new shares. If a company has a substantial number of outstanding shares in the market, it will need to issue more shares to adjust the scrip dividend amount.
It means a scrip dividend program will result in share price dilution. The higher the number of new shares, the more diluted will be the new share price.
It can be seen as a controlled measure by companies growing rapidly. They would like to keep the share price under control so it remains accessible to retail investors and does not affect the liquidity of the share trading.
2. To Retain Cash – Liquidity Challenges
Often companies opt for stock or scrip dividends when they face liquidity challenges.
Borrowing money to pay dividends can send negative signals to the market generally. It would also increase the cost of capital and incur additional expenses for the company.
Therefore, a more viable option for companies will be to issue scrip dividends.
A company may have sufficient cash reserves but is indifferent between issuing cash dividends or project investments. It may decide to retain cash for expansion purposes while issuing scrip dividends to pay shareholders.
3. Manage Gearing
Another challenge for companies is to manage their gearing level. It is the ratio of debt to equity for a company.
When a company issues new shares it reduces the gearing level. However, it can only happen if the company issues a significant number of new shares.
Lower gearing levels can help a company keep the cost of capital lower and also acquire new debt financing due to improved indicators.
4. Offering Tax Advantage to their Shareholders
An overlooked reason for issuing scrip dividends by some companies is to offer a tax advantage to their shareholders.
Unlike cash dividends, scrip dividends are not taxed immediately. Shareholders will be taxed when they sell their shares and make capital gains.
The tax rate for capital gains is usually lower as compared to dividend income in many tax jurisdictions. Therefore, issuing scrip dividends offer certain tax advantages to shareholders as compared to cash dividends.
5. Offering a Choice to Their Shareholders
When companies announce a cash dividend, their shareholders do not have a choice. They receive dividends in the form of cash. It also incurs additional tax obligations on them.
Contrarily, when a company announces scrip dividends, it offers a choice to its shareholders. The shareholders can keep shares to receive capital gains in the long run or sell them to receive cash if they need it.
6. Signaling Effect
Dividend-paying companies have a specific retail investor following. These shareholders look for consistent income through regular dividends.
If a company is unable to pay dividends due to a lack of cash or other issues, it will send a negative signal to the market. In turn, the share prices will fall and the company will bear significant losses.
Therefore, paying dividends as a policy without borrowing helps a company avoid the negative signaling effects.
7. Legal Constraints
Sometimes a company may have a significantly higher gearing level. Lenders may put legal constraints such as the non-distribution of profits to shareholders before paying off debts.
In such cases, even if a company borrows money (which is highly unlikely), it will be unable to pay cash dividends.
The viable solution in these cases is to announce scrip dividends that satisfy shareholder needs as well as comply with the legal constraints.
Arguments For Issuing Scrip Dividends
The board of directors may have contrasting views on issuing scrip dividends as compared to other options.
There are a few key arguments for issuing scrip dividends including:
- It offers an opportunity to existing shareholders to retain their shareholdings
- Shareholders do not need to pay brokerage commission and other costs to buy new shares
- It helps the company in maintaining cash reserves
- It sends positive signals to the market that can stabilize the share prices
- Shareholders can save taxes with lower rates on capital gains taxes as compared to cash dividends
- The company can invest the same cash reserves for investment purposes
Arguments Against Issuing Scrip Dividends
There are a few arguments that go against the scrip dividend policy as well.
A few key arguments against issuing scrip dividends include:
- Shareholders may not like the decisions as they often await cash dividends
- Shareholders may not be able to convert scrip dividends into cash due to restrictions of the holding period
- It may send a negative signal to the market as it shows the lack of availability of cash
- Issuing new shares often results in diluted share prices
- If the share prices fall significantly, the company may lose more than saving through retained cash reserves
Scrip Dividends and the Dividend Irrelevancy Theory
An important concept of dividend decisions for companies is the dividend irrelevancy theory.
It states that if a company reinvests cash reserves in positive NPV projects, it shouldn’t make a difference for the shareholders even if it does not pay a dividend at all.
The total shareholders’ wealth should remain the same as the positive NPV projects will increase the share value (or price).
Scrip Dividend Vs Cash Dividend
The cash dividend is the more conventional form of issuing dividends. Retail and institutional investors often look forward to receiving cash dividends as they require consistent and reliable income.
Companies issuing scrip dividends are often indifferent between the choice against cash dividends.
Cash dividends help a company keep shareholders satisfied. It also keeps the positive signaling effect. Cash dividends are also good for a company looking to keep its share prices stable.
The drawback of issuing cash dividends is that a company may need to borrow money if it does not have readily available cash reserves. Cash dividends also incur higher tax costs for shareholders as compared to stock dividends.
With cash dividends, a company does not offer a choice to its shareholders.
In short, the dividend decisions depend largely on the company policies. However, a company must carefully evaluate the market sentiments and its shareholders’ anticipations.