Dividends and stock repurchases are the two major ways that corporations can distribute cash to shareholders.
Dividends may also be distributed in the form of stock (stock dividends and stock splits), scrip (a promise to pay at a future date), or property (typically commodities or goods from inventory). By law, dividends must be paid from profits; dividends may not be paid from a corporation’s capital. This law, which is designed to protect the corporation’s creditors, is known as the impairment of capital rule. The law stipulates that dividend payments may not exceed the corporation’s retained earnings as shown on its balance sheet.
Companies usually pay dividends on a quarterly basis.
When the company is about to pay a dividend, the company’s board of directors makes a dividend announcement that includes the amount of the dividend, the date of record, and the date of payment. The date on which the dividend announcement is made is known as the declaration date.
The date of record is significant for the company’s shareholders. All shareholders on the date of record are entitled to receive the dividend. The ex-dividend date is the first day on which the stock is traded without the right to receive the declared dividend. All shares traded before the ex-dividend date are bought and sold with rights to receive the dividend (also known as the cum dividend). Since it usually takes a few business days to settle a stock transaction, the ex-dividend date is usually a few business days before the record date. On the exdividend date the trading price of the stock usually falls to account for the fact that the seller rather than the purchaser is entitled to the declared dividend.
Corporate dividend policy is a sometimes underappreciated element of overall company strategy and financial planning. “It’s difficult to generalize about dividend policy because it is usually very company-specific or industry-specific, [but] some general observations are possible,” wrote Frederic Escherich in Directors and Boards. “Dividend policy’s most important uses are to: 1) return excess cash to shareholders; 2) effectively manage the company’s cash needs and capital structure; and 3) credibly signal shareholders about future earnings prospects.” Indeed, when a company puts together its dividend policy, it must decide whether to distribute a certain amount of earnings to the company’s shareholders or retain those earnings for reinvestment. Dividend policy is influenced by a number of factors that include various legal constraints on declaring dividends (bond indentures, impairment of capital rule, availability of cash, and penalty tax on accumulated earnings) as well as the nature of the company’s investment opportunities and the effect of dividend policy on the cost of capital of common stock. Most firms have chosen to follow a dividend policy of issuing a stable or continuously increasing dividend. Relatively few firms issue a low regular dividend and declare special dividends when annual earnings are sufficient.
Opinions vary regarding the relationship between dividend policy and corporate taxation. “The usual argument is that since dividends are taxed as income, they have a tax disadvantage with respect to capital gains in a relatively light capital gains tax regime, especially for recipients in high tax brackets,” wrote Francesca Cornelli in The Complete MBA Companion. “Therefore, other things being equal, companies that pay out high dividends should be valued less than companies that pay out low dividends. In response to this argument, however, economists have argued that the increasing domination of the market by tax-exempt institutions, the reduction of personal marginal income tax rates, the moves in both the UK and US to tax dividends and capital gains at the same rate and the abundance of tax shelters have all combined largely to neutralize the potential tax disadvantage of dividend payments.”