Interworld Distributors has paid quarterly cash dividends since 1980. The divide

Question

Interworld Distributors has paid quarterly cash dividends since 1980. The dividends have steadily increased from $.25 per share to the latest dividend declared of $2.00 per share. The board of directors is eager to continue this trend despite the fact that revenues fell significantly during recent months as a result of worsening economic conditions and increased competition. The company founder and member of the board proposes a solution. He suggest a 5% stock dividend in lieu of a cash dividend to be accompanied by the following press announcement: “In lieu of our regular $2.00 per share cash dividend, Interworld will distribute a 5% stock dividend on its common shares, currently trading at $40 per share. Changing the form of the dividend will permit the Company to direct available cash resources to the modernization of physical facilities in preparation for competing in the 21st century.” Based on your knowledge in this chapter, your ethical reasoning, and additional research (if needed), what are your thoughts of these proposed changes? What are some potential pros and or cons of this decision?

Explanation / Answer

A cash dividend is a payment made by a company out of its earnings to investors in the form of cash.

- This transfers economic value from the company to the shareholders instead of the company using the money for operations. However, this does cause the company's share price to drop by roughly the same amount as the dividend. For example in our case, if a company issues a cash dividend equal to 5% (i.e. $2 on Market price)of the stock price $40, shareholders will see a resulting loss of 5% in the price of their shares.

- Another consequence of cash dividends is that receivers of cash dividends must pay tax on the value of the distribution, lowering its final value in the hands of the shareholders.

- Cash dividends are beneficial, however, in that they provide shareholders with regular income on their investment along with exposure to capital appreciation.

- Further Cash dividends are useful in cases wherein there are NO investible projects.

A Stock dividend is a payment made by a company out of its earnings to investors in the form of shares. For example, if a company were to issue a 5% stock dividend, it would increase the amount of shares by 5% (5 share for every 100 shares owned). If there are 1 million shares in a company, this would translate into an additional 50,000 shares.

A company may opt for Stock dividend considering the following :

- Increase the number of shares of stock outstanding,

- Move some of its retained earnings to paid-in capital,

- Minimize distributing the corporation's cash to its stockholders and invest the cash available in some investible projects.

- Stock dividends are usually Tax free in the hands of the shareholders thereby maximising their return

So in the current case, the company is correct in opting for Stock Dividend thereby making cash available for Modernisation of facility, without in anyway compromising the return in the hands of the shareholders who are free to sell them (stock dividend) in the market and realise the cash.

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