Table of Contents
- 1 DIVIDEND REINVESTMENT PLAN DEFINITION
- 2 DIVIDEND REINVESTMENT PLAN EXAMPLE
- 3 TYPES OF DRPs
- 4 ADVANTAGES OF DRIP
- 5 DISADVANTAGES OF DRIP
DIVIDEND REINVESTMENT PLAN DEFINITION
Dividend reinvestment plan is an option offered by the company that allows shareholders to automatically reinvest their cash dividends in the additional shares of the company. It is also known as DRP or DRIP. Shareholders need to inform the company if they wish to be part of DRIP. Shareholders can choose to invest all or some parts of cash dividend into additional shares under this plan.
DIVIDEND REINVESTMENT PLAN EXAMPLE
|Dividend per share (DPS)||$ 5/ Share|
|Market price of the share||$ 30/ Share|
Let’s say you hold 2000 shares of company X. You have opted for 100% DRIP participation, so all of your cash dividends will be reinvested in additional shares of the company. The market price of the share is $30/ Share and company is offering them 2% discount. So the price would be $ 29.4/ Share. So you will receive 340 shares ($10,000/ $29.4) instead of receiving a dividend of $10,000. Your total holding would be 10,340 shares. The fractional amount forgone because of the rounding off is carried forward to the next dividend payment. ($ 29.4*340= $9,996 < $10,000)
TYPES OF DRPs
This plan is operated by the company itself. The company has a specific department which handles all the aspects of this plan. They also set a specific time when the purchase of shares is permitted. Shareholders can enter a DRIP by directly contacting this department. The shareholders will have to pay no brokerage or low brokerage for receiving the shares. New shares are issued by the company from its reserves in this plan. So, these additional shares can only be redeemed directly through the company. It has no marketability on the stock exchange and it does not affect the market price.
Third Party-operated DRIPs
The company might find managing the DRIP costly and time-consuming. So they use third parties or transfer agents to manage all the aspects related to DRIP.
There are some companies in the market, which don’t have their own DRIP available. Some brokerage houses try to take advantage of this opportunity. They provide an option of DRIP on some shares to their clients. Brokers reinvest the dividends by buying shares from open market. So, Broker-operated DRIPs will affect the market price and shares received through this plan can be sold in the secondary market. Brokers will charge no commission or some commission for this service based on its relationship with clients.
ADVANTAGES OF DRIP
DRIP is a cost-effective method to accumulate shares as company charges no brokerage or some brokerage to shareholders. Some companies also provide a discount on the market price, so shareholders will be able to buy more number of shares against the dividend income. Depending on the market, DRIP manager might take some initial set up fees. However, DRIP is a more cost-effective compared to buying shares from open market every time,
DRIPs are flexible in nature. They provide an option to invest small or large amounts in the plan. So small investor is able to start investing with a small amount also. Due to its flexibility and cost-effectiveness, small investors find it an attractive option.
Power of Compounding
Every time a dividend is reinvested, a shareholder gets additional shares in return. So, if a company increases dividends in future, shareholders will receive more shares under DRIP. For a profitable company, this compounding effect increases the return potential from the investment. This is the power of compounding.
Averaging Out the Purchase Price
Over a long period, DRIP managers try to average out the buying price for the shareholders. When share prices increase investors receive less no. of shares for reinvesting dividend and vice versa. Using this system, shareholders’ buying price comes to an average level which is unaffected by fluctuations in the stock price.
Source of Capital
Company-operated DRIPs are a great source for the company to create more capital. The company will be able to raise this capital at a low cost because it is a direct transaction between shareholders and company.
Shareholders who have opted for DRIP will generally invest with a long-term vision of growth. So, this will create a loyal base of shareholders for the company. These shareholders will generally not sell the shares when market prices fall and it must be sold back to the company.
DISADVANTAGES OF DRIP
Availability of DRIPs
One of the issues with the DRIPs is that they are not offered by all the companies. So, investors will have to opt for broker-operated DRIPs which are costlier than company-operated DRIPs.
Burden of Record Keeping
Shares received through DRIPs are subject to capital gain tax. Shareholders who opted for DRIP will have to keep a record of every transaction, the prices at which buying/selling was done and capital gains/losses. For example, you held shares for 10 years and company paid dividend 20 times during that period. So maintaining all the data required by tax authorities for 20 transactions can be time-consuming and burdensome.
Each time a company issues new shares against the dividend, the shareholdings gets diluted. Those shareholders who have not opted for DRIP will see their shareholding getting diluted.
Risk due to increased exposure
DRIP will increase the exposure to one security in the portfolio. Unless shareholder is very sure about company’s growth prospects, he/she should not opt for DRIP. Shareholders should regularly analyze the company and the economic outlook. Based on that analysis, rebalance his/her portfolio by changing the amount of exposure to that company.
CFA Level 1 Curriculum, 2016