What is a Cash Dividend?
How Does a Cash Dividend Work?
Let's assume you own 100 shares of XYZ Company. At the end of the quarter XYZ Company calculates its financial performance for the quarter. The board of directors then reviews this information, including XYZ Company's profit margin, and declares a $0.10 dividend per share for the quarter. This means that you are entitled to $0.10 x 100 shares = $10.
There are several important dates to note when a firm's board of directors declares a dividend. These include:
- Declaration Date: This is the date on which a company's board of directors declares that a dividend will be paid. The board determines the amount of the dividend, as well as when it is to be paid to shareholders of record.
- Record Date: This is the date on which a company reviews its books to determine its shareholders of record. Shareholders who hold a particular stock on this date will receive the firm's dividend payment.
- Ex-Dividend Date: After the Record Date has been determined, the stock exchanges or the National Association of Securities Dealers (NASD) assign the ex-dividend date. The ex-dividend date for stocks is typically two business days prior to the record date. If an investor buys a stock before the ex-dividend date, then he or she will receive the dividend payment. If an investor purchases the stock on or after the ex-dividend date, then he or she is not entitled to receive the dividend.
Why Does a Cash Dividend Matter?
Many things influence the timing and size of dividends. Dividend-paying companies typically pay on a regular basis (usually quarterly), but in general a corporation is not required to pay dividends, even if it has done so in the past. Even if a company declares a dividend, some of the company's shareholders may not be eligible for it. Companies with more than one class of stock often set forth dividend preferences among those classes. Furthermore, corporations do not always have to pay dividends in cash. In some cases they may pay dividends in stock, although this kind of dividend is generally paid at infrequent intervals. Corporations may also give shareholders a choice between cash and stock or allow shareholders to purchase additional shares of stock with their cash dividends (this is called a dividend reinvestment plan). Occasionally, a company will declare an extra dividend if they had a particularly good year or may pay a dividend when it is going out of business, in which case the dividend is essentially a distribution of the proceeds of asset liquidation.
Companies may employ certain financial strategies when determining the size of a dividend. Some may use dividends to maintain specific financial ratios and some may fix the dividend as a percentage of earnings in order to manage any cyclical tendencies of the business.
Companies fund dividends with profits, but they are not required to pay out 100% of their profits in dividends. They can reinvest all or some of their profits if their boards deem it appropriate. There is usually some controversy about which use of profit is most beneficial to a company's shareholders. Even though reinvested profits may raise the value of the corporation over the long term, dividends can be an important source of current income for shareholders. In general, however, companies pay dividends when the rate of return on their reinvested profits falls below their dividend yields.
Older, more mature companies generally pay more dividends than fast-growing companies, which are usually more focused on reinvesting cash in order to grow the business. However, an unusually high dividend over time can foreshadow a cut in dividends when the company encounters a need for cash. It is important to understand that capital needs and investor expectations vary from industry to industry, which is why comparison of dividends and dividend payout ratio ratios is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.
The market generally regards the cessation or reduction in dividends as bad news. For this reason, companies sometimes become "addicted" to dividends even when their earnings can no longer support the practice. It is also important to note that if a corporation's board of daIRSectors declares a dividend that would come out of the corporation's capital surplus or would in any way make the company insolvent, some state laws may declare the dividend illegal.
The fact that dividends are a series of cash flows extending indefinitely into the future plays an important role in stock pricing. Changes in the size and timing of dividends affect stock prices because the dividend discount model, a widely used equity analysis and valuation tool, equates a stock's value to the present value of its future dividends. Under the DDM, a stock becomes more valuable when its dividend increases or the expected dividend growth rate increases.
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