Hi to all, I will appreciate if someone will help me regarding the following question from Kaplan. Which of the following is most likely to increase shareholders’ wealth?
A. a stock dividend,
B. a stock split,
C. a special dividend.
According to the book, the right answer is C. But the explanation is not convincing for me. I will appreciate if someone will post the logic here for me.
Thanks in advance.
Consider each answer and find a reason why it is not correct.
First, a stock split is like dividing a $100 into two $50 bills. No increase in wealth.
A stock dividend is when company gives its shareholders more stocks. Say you had 100 shares you get 5 shares as a gift. You would think it makes you richer but not really. The net value of the company hasn’t changed. The total number of shares outstanding has increased but each share price has dropped so that market cap remains constant.
A special dividend is a cash reward, just like ordinary dividend, except it is a one-off event. It makes you richer because it is cash and value is transferred from company to shareholders.
A 5% stock dividend is nothing more (nor less) than a 21:20 stock split.
krokodilizm, thanks for the explanation. It is a comprehensive one. I definitely agree with your first 2 points, but I have somewhat different opinion on the third. I agree with you that a special dividend is a cash reward, just like ordinary dividend. However, after the dividend the stock price drops in amount of the dividend (assuming no taxes on dividends) and the shareholder wealth does not change. It is just divided into to groups (stock, which is priced less than before-dividend-stock-price in amount of dividend, and cash, which is equal to the dividend distributed), so that the shareholders’ wealth is not changed in this case as well.
Correct me if I am mistaken or did not account something.
Thanks in advance.
While theoretically dividends don’t increase shareholder wealth due to price change after ex-div date, there’s a possibility dividends don’t cause the expected tax-adjusted price change. This possibility creates shareholder wealth.
For special dividends, this possibility is more likely as it sends a strong signal about future prospects.