Definition of Stock Dividend
Stock dividend can be defined as a form of dividend distribution undertaken by companies with a poor liquidity situation under which existing shareholders are allotted either additional company shares or shares of any of its subsidiaries based on the number of already owned shares instead of distributing profits in cash.
Stock dividends are the dividends paid in stock rather than paying cash. It is a method of rewarding the shareholders without affecting the company’s cash balance. Issuing additional shares will dilute earnings per share (EPS) and market price per share (MPS). These dividends are generally paid for infractions as a percentage of existing shares. Such dividends are not taxed until the owner sells these shares. Unlike cash dividends, stock dividends do not increase the shareholder’s wealth but only increase the number of shares held, lowering the market price per share. Simply put, it is a dividend where companies distribute profit to investors by allotting additional company shares in place of cash dividends. Accordingly, an investor can get a healthy return from the company, and the company also doesn’t lose its cash.
How Does It Work?
- Stock dividend is the distribution of shares in place of cash dividends. It is generally distributed when the company wants to reward its shareholders and investors but doesn’t have a cash surplus or needs them for future investments. Stock dividends are also advantageous for investors from a tax point of view, as the tax is levied only when the investor sells the shares or until the company offers the holder to take the share or redeem it against cash. Companies may place restrictions on trading for a certain period after the issue of such shares. The holding period of stock dividends starts from the date it is purchased. Therefore, it is necessary to understand the holding period to determine the qualified tax treatment of dividends. If the stock dividend comes with the cash dividend option, it will be liable to be taxed even if it is not sold.
- It is essential to understand how the stock dividend functions. A stock dividend will not have any impact either on the shareholder’s fund or on the cash balance. Since no cash is distributed, the cash balance remains unaffected. But why shareholders’ values don’t change?
- To answer the above question, we need to understand that declaring and distributing stock dividends is the conversion of retained earnings or any other reserves into share capital. A journal entry will be passed with a debit to Reserves and surplus and credit to share capital A/c. Since both resources and surplus and share capital are components of shareholders’ funds, a debit and equivalent credit will result in the shareholder’s fund remaining unchanged.
Example of Stock Dividend
James, a shareholder of Walmart Inc., holds 2000 shares. The company has not earned a good profit and therefore decided to declare a 20% stock dividend. The current stock price is $20, and there are 2,00,000 shares outstanding. Determine the effect of dividends on James’ holdings.
Calculate new MPS and determine the effect on shareholders’ funds.
- The market capitalization of Walmart Inc. before dividend declaration-
2,00,000 * $20 = $40,00,000
- The total increase in outstanding shares-
2,00,000 shares * 20% = 40,000 shares
- Total shares outstanding after a 20% increase
2,00,000 + 40,000 = 2,40,000
- James new ownership
2,000 shares + 20% = 2,400 shares
- Price per share of Walmart Inc. after stock dividend-
Market capitalization / Total outstanding shares (Since market capitalization remains unaffected)
$40,00,000 / 2,40,000 = $16.66
Hence declaring of stock dividend does not affect market capitalization but increases the number of shares.
Impact of Stock Dividend
With the declaration of a stock dividend, there is no actual increase in the value of shareholders’ funds. What gets affected is the price of a stock in the same manner as in the case of cash dividends. When the stock dividends are declared, the stock price often increases, but as the stock dividend increases, the number of outstanding shares and, therefore, the company’s value remains the same; hence, it dilutes market value per share. Since the overall market capitalization remains unchanged, the stock dividend does not impact shareholders’ net worth. However, it can generate liquidity for shareholders. Since the number of shares increases, shareholders can sell some shares while retaining the balance.
Journal Entries for Stock Dividend
Genius Inc. has 10,000 common shares outstanding and declares a 10% stock dividend. The par value of a stock is $10. The market value is $100. Pas journal entry for its accounting
Number of new shares to be issued –
10000 * 10% = 1000 shares
Journal entry on the date of declaration
|—-||Retained Earnings A/c Dr.||1,00,000|
|To Dividend Payable A/c||1,00,000|
|(Being Stock dividend announced by the company)|
|—-||Dividend Payable A/c Dr.||1,00,000|
|To Common Stock A/c||10,000|
|To Paid in Capital in excess of Par A/c||90,000|
|(Being Stock dividend distributed by the company)|
Some of the advantages are given below:
- Stock dividend proves advantageous for the company as it honors its commitment to dividend distribution without affecting its working capital. Providing stock dividends helps save cash outflows and does not affect its liquidity. During hard times when the company doesn’t have sufficient cash to pay dividends, stock dividends are constructive in such a situation. The net cost to the company of stock dividend is negligible.
- Cash dividends are considered income in the year of receipt and are liable for the tax, whereas stock dividends are not taxed in the hands of shareholders unless sold.
- By issuing stock dividends, a company can increase the liquidity of its shares as it increases the number of shares in the market.
Some of the disadvantages are given below:
- The market may observe the declaration of stock dividends as a liquidity shortage. The market participants might feel that the company is in a distressed position and is facing a liquidity crunch, which in turn may negatively impact the company’s share market price.
- As the stock dividend does not increase shareholders’ wealth immediately, some might get dissatisfied as the company didn’t pay anything in cash.
- The stock dividend will always lead to a falling share market price, which confident investors might not understand well. This, in turn, creates selling pressure on the stock.
A stock dividend can be rewarding shareholders with the company’s additional shares instead of paying them in cash. The stock dividend does not impact a shareholder’s net worth. However, it increases the number of shares in the market, generating additional liquidity for shareholders. Declaring stock dividends instead of cash dividends may be taken both positively and negatively simultaneously by different stakeholders. While some may take it as a company facing liquidity crunch issues) and others may take it as savings for reinvestments in future business development and growth.
This is a guide to Stock Dividend. Here we also discuss the definition and how it works, along with its advantages and disadvantages. You may also have a look at the following articles to learn more –