Definition of Dividend Reinvestment Plan
In a Dividend Reinvestment Plan, i.e., DRIP or DRP, the company offers a plan to the shareholders of a company in which a dividend is not paid in cash to the shareholder on the date of payment of a dividend; rather, the same is reinvested by the company in the additional shares of the company generally at a discounted price.
Explanation
When any company pays a dividend to its shareholder, then the shareholders receive that amount in their bank account, but in the case of the dividend reinvestment plan, existing investors or shareholders are provided with the option to invest their dividend amount in the share of that company instead of receiving the dividend in cash. These shares are generally available to investors at a discounted price. To acquire these shares from the company, either no commission is paid, or nominal charges are paid. Generally, these plans are offered to the existing investors, but sometimes a company may offer the same to the new investors at a certain minimum amount.
Characteristics of Dividend Reinvestment Plan
Characteristics of the Dividend Reinvestment Plan are provided and discussed below:
- It is a program, in which an investor of the company is allowed to reinvest its dividend amount in additional shares of the company instead of receiving cash against it.
- In DRIP, the acquisition process is automatic, so investors have no control over the time of acquisition, and if shares are acquired either the price is low or high.
- The holding of shareholders increases at a low cost.
How Does it Work?
The company pays dividends to the shareholder on its due date. The shareholders in their bank account receive this amount. But sometimes company offers a plan to the shareholders to invest this dividend amount in other new shares of the company. The investors or shareholders who are interested in increasing their investment in the company can go for this Dividend Reinvestment Plan. As they are existing shareholders, these shares are provided to them generally at a discount. These shares are not provided through Exchanges as the same originated from the company’s own reserves. Here, the company kept complete and detailed records regarding the ownership percentage of shares.
Example of Dividend Reinvestment Plan
Suppose Mrs. Grudge holds 2,000 shares in a company, and the dividend is payable at $ 20 per share. In between, the company offers the dividend Reinvestment plan to Mrs. Grudge, according to which, on the due date of the dividend, the dividend is reinvested into the shares of the company at a 20% discount where the market price of the share on the dividend date is $500 per share. Mrs. Grudge accepted the offer and participated in the plan. She has decided to invest a 100% dividend in this plan as she wants to enhance her investments in the company.
Analysis: On the due date of the dividend, she is eligible for a dividend amounting to $40,000 (2000 shares * $20), and as she participates in the plan, this dividend amount is invested in the shares of the company at a discount of 20% on the market price on the due date.
Reinvestment Rate is calculated as
Reinvestment Rate = Market Price – 20% of Market Price
- Reinvestment Rate = $500 per share – 20%* 500
- Reinvestment Rate = $500 – $100
- Reinvestment Rate = $ 400 per share
With this price, Mrs. Grudge now invests in extra shares of a company which is calculated as below:
- = Dividend Amount/ Reinvestment Rate
- = ($40000/$400 per share)
- = 100 shares
Thus after reinvestment in total, she owns 2,100 (2,000+100) shares of the company. This process works in the same way.
Types of Dividend Reinvestment Plan
Dividend Reinvestment Plans are of three types that are provided and discussed below.
- Dividend Reinvestment Plans operated by the company – Here, the company runs its own plan and controls the functioning of this plan specific department is made in the company.
- Dividend Reinvestment Plans operated by the third party – As the DRIP operated by the company is too expensive and time taking for the company, so company outsources the handling of this plan to the third party.
- Dividend Reinvestment Plans operated by the Broker – Here, the DRIP is not offered by the company but offered by the broker to the shareholders on some investments for which the broker may charge some nominal amount of commission.
Best Dividend Reinvestment Plans
BEST DRIP in which the shareholder can invest are provided and discussed as below:
- In Honeywell, the growth of dividends is balanced and stable in past years.
- Johnson & Johnson is a high-yielding company, and here payout ratio is also increasing year by year.
- Emerson Electric is a manufacturer of industrial equipment which provide stable and increased dividends for the past 60 years.
- ExxonMobil has also increased the dividend payout constantly for many years.
- Abbvie Inc. has also increased the dividend payout constantly for many years.
- Kellogg Co is the strongest company in the payment of dividends if we compare it with other similar product-based companies.
Dividend Reinvestment Plan vs Growth Plan
In the growth plan, instead of paying a dividend to the shareholders from the profits of the company, these profits are invested by the company. Here the number of shares held by the shareholders remains the same, but the value of the share increases. It means the shareholders earn more value now from the same numbers of shares than they earn before this plan. But in the Dividend Reinvestment plan number of shares held by the shareholder’s increases as they get new shares in place of dividends.
Benefits of Dividend Reinvestment Plan
Benefits of the dividend reinvestment plan are provided and discussed below:
- A dividend Reinvestment plan is cost-effective for the shareholder as the shares are available at a discount, and no commission is charged on the acquisition of shares.
- It is beneficial for the investors as they get an increased return. In DRIP, a dividend is automatically reinvested into the shares of the company. At the time of payment of the next dividend, the shareholders also get the dividend on these extra shares received under DRIP. This process goes on, and the returns of shareholders increases.
- It is beneficial for the company as it gets shareholders for the long term because generally, the shareholders with the intention of the long-term investment may opt for DRIP, and it also helps to raise capital for the company.
Disadvantages
Disadvantages of the dividend reinvestment plan are provided and discussed below:
- In DRIP, the acquisition process is automatic, so investors have no control over the time of acquisition, and shares are acquired even though the price is very high.
- By participating in DRIP, the investments of investors in one company increases. This will result in an undiversified portfolio.
- This plan is not appropriate for investors who want to make short-term investments in the company and who are dependent on dividend income for their daily expenses.
Conclusion
Thus, the shareholders receive a dividend on their investments in the company on the due date of the dividend. But if the shareholders participate in DRIP, this dividend amount is not credited to their bank account and is automatically invested in new shares of a company at a discounted price. This DRIP is operated either by the company or by a third party. It is cost-effective for shareholders and also beneficial for the company as it gets long-term investors, but it may also lead to an unbalanced portfolio of investors.
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