Before the Board of Directors declares a cash dividend, it needs to ensure that it won’t break any restrictive covenants that are in place. A restrictive covenant, for instance, can prevent a company from paying dividends if after paying them there wouldn’t be enough cash to pay the bondholders. Also, there are corporate laws in various jurisdictions that restrict dividends if certain provisions aren’t met. The company also needs to ensure there will be enough money to pay preferred shareholders and to maintain proper working capital.
When a cash dividend is declared it contains four dates: declaration date, ex-dividend date, record date, and payment date. The first one is obvious since it is the date of an announcement. Right after this date, the price of the stock of a company is increased by the amount if the declared dividend, therefore, it can be said that the stock trades with the dividend attached. It happens in order to prevent speculators from buying the stock for short-time just to get the dividend.
The ex-dividend date is usually a couple of trading days before the stock dividend record date. Based on the record date, companies know who gets the declared dividends. So, on the ex-dividend date the dividend’s value is dropped from the price of a stock. If the stock is bought on this date or after, no dividend will be paid because the standard settlement takes three business days. Therefore, if someone buys the stock on the ex-dividend date, and the record date is two days after, the transaction will not settle for three days, which is a day after the record date. As a result, no dividend is paid.
In the United States, cash dividends are typically paid quarterly.
Some companies reward their shareholders with stock dividends. Technically, when shareholders receive extra shares, it doesn’t create any value as more shares are outstanding and the stock price drops. However, if a company also pays cash dividends, and intends to pay the same dollar amount, then the extra shares generate more income for shareholders. Also, if the stock price drops, like with stock splits, then it may become more attractive for investors to buy it.
Coming to stock splits, these don’t increase intrinsic value of a company, but investors like them. If there’s, for example, 3-1 split, for every share the investor will get three shares. There are also reverse stock splits, such as 1-10. Here for 10 shares the investor gets only one, while the stock price increases tenfold. If there are fractional shares, typically investors get cash for them. So, if an investor holds 11 shares this would represent 1.1 new shares. In that case, cash would be paid for the fraction of 0.1.
Generally, companies do reverse splits when their stock price drops below $1. Often, this is done to maintain NASDAQ listing. Many penny stock companies do it. Reverse stock splits are generally badly received by investors as they give an indication that the company isn’t doing well and doesn’t expect its stock price to rise. Often, reverse stock splits lead to subsequent sell offs.
Companies may decide to spin-off one of their divisions. In such cases, shareholders can get shares of a new company, and still hold the shares of the old company. Technically, the shares they originally had lose value as spin-off makes the original company less valuable, but that is replaced in value arising from the issuance of new shares. A major reason for a spin-off is to unlock the value of a division that’s being spinned off. Generally, this is perceived as a positive development by the shareholders.
Mergers & Acquisitions
When a merger happens, two companies combine to form a single company. Often, stocks A and B will be combined into stock C. When an acquisition happens, one company buys the other. If the other company is also publicly listed, the shareholders of the acquired company get shares of the buying company, although in some situations they get cash. Sometimes, when an acquisition happens, the shares of the buyer drop, while the shares of the seller rise, especially if a price for the target was paid well above its market price.
These dividends are uncommon. Usually, when a company decides to close operations (i.e. go out of business), it will return capital to shareholders. At times, a company that intends to operate will sell one of its divisions or some assets, and then distribute cash to its shareholders.
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Corporate actions can be confusing to investors. We are here to help by explaining.
Mandatory corporate actions include cash and stock dividends, stock splits, spin-offs, mergers & acquisitions, and liquidating dividends. When an action is mandatory, it means it will happen and the investor doesn’t need to do anything. Some mandatory corporate actions come with options. One example is an option to choose between a cash dividend or to buy shares of a company with it. These are also known as dividend reinvestment options. For a mandatory corporate action with options there will be a default option. So if an investor fails to reply with a choice, the default option will automatically apply. For mutual fund investors, portfolio manager decides as to which corporate action to choose (if there is a choice given).