Effects of Special Dividends and Why Firms Pay Dividends

Effects of Special Dividends and Why Firms Pay Dividends

The frequencies at which a company pays its dividends and the rate of dividends are significant factors that not only do they attract investors but also measure the performance of a corporation. Furthermore, at different times companies issue varying dividends rate to the shareholders. The difference in the varying rates of dividends is as a result of world factors. However, at a point, the company may issue special dividends which are not planned for and come as a surprise to the shareholders. The preceding chapters will focus on the effects of paying special dividends and also why do firms pay dividends and what causes the rate of dividends to vary about Linear Technology.

Effects of paying special dividends

Special Dividends are payments made by the company to the shareholders, which are separate payments from the regular dividend payment. In most cases, the special dividends are usually much higher than the regular payment. Firms pay special dividends for various reasons: one, to reduce the excess capital the firms has which might be risky to invest it, hence resulting to the firm rewarding the shareholders in the form of special dividends. Two, reduce the tax due from the firm on dividend tax. For example, Bush-era tax cuts increased the dividend tax from fifteen percent to forty-three point three percent, to reduce the tax due on the dividends; the firm had to pay special dividends before implementing the policy.

When Linear Technology issues the special dividends from cash balance, the company’s value will decrease. Issuing of special dividends happens in the following ways, on the declaration of the special dividend by the board of directors, the retained earnings will reduce, and this is because the special dividends will be paid out of the retained earnings. The current liabilities of the firms increase as the dividend payable account increases due to the amount due from the special dividends declared. However, on paying the dividends, the current liabilities (dividend payable) decreased and also the account cash decreases. Hence, the net value of the enterprise reduces.

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On issuing of special dividends, the share prices of Linear Technology reduce. The reduction of the share prices on issuing of special dividends is as a result of the following instances. First, to predict when the company will give the special dividends is hard and after prediction, the results may nearly be all incorrect, making it hard to determine the cum-dividend price of the shares. However, after declaring the dividend, the ex-dividend price can be determined. When the company declares special dividends, the company’s value reduces due to a reduction in cash balance. After declaring the special dividends, the value of the shares will be less the amount of the dividend declared. For example, assuming that Ex-dividend market share price of the Linear Technology was $40.00 and the company declared a special dividend of $2.00, the share price value (cum-dividend) will be $40.00-$2.00=$38, showing a decrease in the value of the stocks of the company.

Issuing special dividend reduces the company’s earnings. If a corporation has preferred stock in its capital structure, the total amount of the special dividends for the preferred stock will be appropriated (deducted) before the net the company’s net earnings for the year is computed, resulting in decreasing in the net earnings for the year. Furthermore, the special dividend for the common stock will reduce the amount transferring to the retained earnings reserves. As a result, the cumulative earnings that a company is getting are reduced by issuing special dividends.

The Earnings per Share reduce respectively with the issue of special dividends. By issuing dividends, Linear Technology will have to utilize all the cash to pay for the dividend. With the reduction in Earnings per Share, the company has an increase in liability and a decrease in the business’s assets. Earnings per Share is the portion a company’s share gets, allocated from the profits. Since the profits have reduced while issuing the special dividends. Also, the portion that each common stock share gets reduces hence a reduction in Earnings per share.

Repurchasing shares instead of issuing special cash dividends is a matter that has its most appropriate time of doing. For example, if there is an over value of Linear Technology stocks, the most appropriate step to take would be issuing the special cash dividends. However, if the shares are undervalued the best step to take would be to repurchase shares. Repurchasing shares results to increase the equity of the company, hence the value of the company will not be as less as when the company would have issued special dividends. Still, the regular dividends paid would be less as earnings per share would be a smaller amount compared as to when the repurchasing of shares. As a result, a company’s earnings would be distributed over an enormous number of shares reducing the regular dividends declared and also earnings per share. Besides, repurchasing shares would be attracting a dividend of 3% which would not have been the case with special dividends. Meaning there is an increase in the cost of equity as the repurchased shares would continuously attract a dividend interest of 3% in comparison to no cost incurred in interest by issuing the special dividends out of the cash balance. When repurchasing shares, the shareholder does not pay the tax on the dividends declared as compared to when he would have received the special dividends in cash, this increases the value of the special dividend paid if it is used to repurchase the shares.

Reasons why firms pay dividends

            Paying of dividends is not essential for a company, but most companies consider paying dividends because of the following reasons. One, dividends make the stock look more attractive to investors as investors are more attracted to stocks that pay dividends due to volatility. Also, by paying dividends, the stability of company’s stock price is enhanced. As a result, dividends paying stocks suffer a smaller loss in a down market due to stability enhanced by paying dividends. Two, dividends increase the investors’ confidence in the company. It is only by paying a dividend that a firm can practically prove to its shareholders that the profits made were real. Additionally, dividends provide assurance of the company’s financial prosperity, as the management indicates that the company can continue to remain profitable. Three, Companies pay dividends as a way to pass the companies’ profits to the shareholders. Some companies have moved past the growth rate, and one of the ways they can ensure their share prices remain high is by the issue of dividends.

Reason a firm would repurchase its stock

The main reason that will make a firm repurchase its stock is because of undervaluing the firm’s shares. Repurchasing the stock makes the company get shares for less value that the initial value.  For example, if the company’s shares are valued at $2 with an intrinsic value of $3, the company will have the $3 share for $2. Also, a company may repurchase its stock to increase earnings per share, but after careful analysis, the value of the firm does not change with repurchasing of shares, what changes is the denominator while calculating the earnings per share. A company might repurchase to (or “intending to”) kill two birds with one stone. First, the company may repurchase its stock to keep its investors happy, hence attracting more investors. Second, the company may repurchase its stock to reinvest the money in other areas that have more rate of return than compared to the cost of equity with the repurchased shares.

Factors that cause the rate of dividend to change

The rate of dividend changes because some financial analysts believe that no dividend policy is perfect for the firm. Investors are capable of tailor making their channels of investing such as investing in bonds that have a constant interest than a dividend paying stock whose interest is varying. As a result, companies have to keep on adjusting their dividends rate to cope up with the bonds and other financial instruments rate, to attract the investors.

Also, the firm may want to invest some of the profits earned in the fiscal year, hence by altering the dividends rate, makes the firm achieve the amount of money it wants to re- invest. Taxation rate influences the dividend rate, as an increase in taxation rate, may have a ripple effect on the rate of dividends, making the company alter the rate so that after tax the shareholders may have something significant as a dividend. Else, the company can reduce the dividend rate so that more shareholders can repurchase the shares, which will later the sell the shares resulting to capital gain which has a less tax compared to dividend tax.

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Conclusion

Special dividends attract investors to the company, resulting in an increase in the market price of the shares. Firms pay dividends as a way to share the company’s profits with the shareholders. The tax imposed on the dividends plays a significant role in determining the rate of declaring the dividends.

 

 

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