Forms of Dividends: Cash, Bonus Shares, and Stock Splits

Companies have several options for distributing value to shareholders, with cash dividends being the most common. This section explores different forms of dividends and a related action – stock splits – and their implications.

1. Cash Dividend

• Description: The most prevalent method, where companies distribute a portion of their profits to shareholders in cash.
• Requirements:
  • Sufficient Cash: Companies must have enough cash on hand or arrange for borrowing to cover declared dividends.
  • Cash Budgeting: Stable dividend policies necessitate careful cash budgeting to ensure funds are available.
• Impact:
  • Company: Reduces the company's cash account and reserves, decreasing both total assets and net worth.
  • Shareholders: The stock price often drops by the amount of the dividend.

2. Bonus Shares (Stock Dividends)

• Description: A distribution of additional shares to existing shareholders at no cost. It supplements cash dividend.
• Proportionality: Bonus shares are distributed proportionally to existing holdings, meaning no dilution of ownership occurs. For example, a 10% bonus issue (1:10) gives 10 extra shares for every 100 shares held.
• Impact:
  • Company: Increases paid-up share capital, reduces reserves and surplus (retained earnings). The total net worth (paid-up capital plus reserves and surplus) remains unaffected.
  • Shareholders: Shareholders share is increased proportionately. It is not taxable as income, can sell the new shares received.

3. Advantages of Bonus Shares

To Shareholders:

• Tax Benefit (Context Dependent): Historically, bonus shares were advantageous due to favorable tax treatment compared to cash dividends. Tax laws vary by location, they may or may not be more attractive than dividends.
• Indication of Higher Future Profits: Bonus issues can signal management's confidence in future profitability.
• Potential for Increased Future Dividends: If a company maintains its per-share dividend payment after a bonus issue, total cash dividends received by shareholders will increase.
• Psychological Value: Receiving bonus shares can have a positive psychological effect, leading to increased investor confidence.

To the Company:

• Conservation of Cash: Allows the company to distribute value without using cash needed for investments.
• Means to Pay Dividends Under Financial Difficulty or Contractual Restrictions: Can be used when cash flow is strained or loan agreements restrict cash dividend payments.
• More Attractive Share Price: Can reduce a high share price, making the stock more appealing to small investors and increasing trading activity.

4. Limitations of Bonus Shares

• Shareholder Wealth Remains Unaffected: In theory, bonus shares themselves don't create value. They simply divide the ownership of the company into more pieces.
• Costly to Administer: Issuing bonus shares involves administrative costs.
• Problem of Adjusting EPS and P/E Ratio: Following a bonus issue, earnings per share (EPS) and price-to-earnings (P/E) ratios need to be adjusted, which can create confusion.

5. Stock Split

• Description: An action where a company divides its existing shares into multiple shares, increasing the number of shares outstanding and decreasing the price per share. For example, a 2-for-1 stock split doubles the number of shares and halves the price per share.
• Purpose: Primarily aimed at making the stock price more attractive to a wider range of investors, thereby increasing liquidity and trading volume.
• Similar to Bonus Shares: The economic effect of a stock split is similar to a bonus issue, but it involves a change in the par value of the shares.

In effect, the stock split would help lower share prices and increase trading activities of the business.