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Dividend reinvestment plans – helpful or harmful?

Reported by Mike King, The Motley Fool.
Monday, December 17, 2012
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Dividend Reinvestment Plans (sometimes abbreviated to DRPs) allow shareholders to take part or all of their dividend in the form of additional shares rather than cash, with no transaction or brokerage costs

Some DRP plans offer shares at a slight discount to the share price as an additional benefit.

Advantages to the company are that instead of paying out cash, they are issuing shares, which keeps cash in the company’s coffers. For example, the big four banks may only have to pay out 75% of the cash allocated for dividends, with the other 25% staying in the bank for reinvestment.

For shareholders the advantage is that when its done right, over a long period and through a holding in a solid company like Woolworths (ASX: WOW), shares can be purchased at all stages of the economic cycle, so some may be really cheap, whiles might be expensive, but over time should even out.

The decision about what to do with the dividend cash is taken out of the hands of the shareholder, so they don’t need to make a decision on where to reinvest or even whether to reinvest the funds.

Of course, no matter whether you take the cash or dividends, you still have to pay tax on the ‘value’ you receive. (Remember, the DRP is essentially an automatic reinvestment of your dividend – saving you the hassle of receiving the cash, then buying the shares on the market.)

The disadvantages are, if the company is not a good solid company and as a worst case scenario, investors may end up with more shares in a company that goes bust, and have not received any dividends to offset the loss.

Underwritten DRPs

The Claytons dividend – It’s a sneaky way of declaring a dividend, but then not paying one – a move that could be declared as ‘not in the best interests of shareholders’.

The company will issue shares to fund the full dividend amount. If a shareholder chooses to participate in the DRP, then the company will issue the shares to you. If you choose to receive the cash instead, the shares will be issued to another party, and use the cash it gets from them to pay your dividend.

In other words, the company doesn’t really pay out any net cash – all of the cash that’s paid is returned to the company through the issue of those new shares.

When a company continues to pay underwritten dividends, your  holding in the company will very quickly get diluted, if you choose to not participate in the DRP. In other words, your percentage holding of the company will shrink each time the company declares a dividend.

It’s a sneaky way of declaring a dividend, but then not paying one – a move that could be declared as ‘not in the best interests of shareholders’. It’s best to give any company doing this, a black mark against their name – such as National Australia Bank (ASX: NAB), Bank of Queensland (ASX: BOQ), Billabong International (ASX: BBG), ANZ and Westpac in recent times.

There may be reasons for a company wishing to keep some of that money – because it has growth opportunities it needs to fund, for example – but in those circumstances, we’d rather the company simply reduce or suspend the dividend. The result is the same for the company, and fairer for shareholders.

Advantages for shareholders

  • It’s a ‘set and forget’ process to continue re-investing in companies
  • Don’t have to decide where to invest the dividend
  • Slice of pie, or “share of the company” remains the same
  • Are sometimes issued at a slight discount e.g. 5% to the current trading price, and without brokerage or transaction fees
  • Can take all or part of the dividend as new shares, and participation is voluntary, so shareholders can elect to participate in some years and not in others
  • Shares issued under the DRP rank equally with ordinary shares and can be sold as soon as they have been allocated to the shareholder.

Disadvantages for shareholders

  • Takes the investing decision out of your hands, and DRPs for some companies and at some periods can be a bad decision
  • Slice of pie can shrink, and majority shareholders can increase their holdings
  • Can make tax decisions difficult, when selling e.g. if significant capital gains within 12 months on shares issued under DRP, full rate of capital gains tax is payable, whereas shares purchased more than 12 months before selling are eligible for 50% discount on tax, if there’s a capital gain
  • Can make administration difficult – tracking shares issued, cost base prices. As an example, if you hold shares in a company for 20 years and it issues dividends twice a year, you would need to keep track of 40 separate transactions for tax purposes – and that’s just for one company
  • Companies can suspend DRPs whenever they want
  • Some companies will set a limit on the number of share participating e.g. Woolworths’ limit is 20,000 shares.

Advantages for companies

  • Don’t have to pay out the full dividend amount in cash
  • Results in an increase in invested capital

Disadvantages for companies

  • Administration expenses of issuing new shares and setting up a DRP account for each shareholder who participates, rather than just paying out cash
  • Increases the number of shares on issue, so can dilute earnings per share – a number that many companies use to calculate executive pay and bonuses.

Here’s a few examples of companies that currently have active DRPs.

Woodside Petroleum (ASX: WPL) – No discount to trading price, no limit on number of shares per shareholder.

Suncorp Group (ASX: SUN) – No discount to trading price, no limit on number of shares per shareholder

ASX Limited (ASX: ASX) – No discount to trading price, no limit on number of shares per shareholder.

Origin Energy Limited (ASX: ORG) – No discount to trading price, no limit on number of shares per shareholder.

Woolworths Limited (ASX: WOW) – No discount to trading price, 20,000 limit on number of shares per shareholder.

If you only invest in one company this year, make it our “Top Stock for 2012-13.” Operating in two hot markets — one set to double by 2012, the other predicted to grow 5x over the next five years — this stock is a solid growth play that also boasts strong recurring revenue, zero debt, and lots of cash. Get its name and full research case in this brand-new FREE report.

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Motley Fool writer/analyst Mike King owns shares in Woodside and Woolworths. The Motley Fool’s purpose is to help the world invest, better. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

22/10/2014 02:08Sydney, Australia. 22 October,2014
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