Question

If a company used cash to pay a dividend of $8,000,000, and also issues more shares to new shareholders to replace the cash. What happens to the market value of the existing shares and shareholders’ wealth?

Answer 1

EFFECT OF ISSUANCE OF DIVIDEND

The effect of dividends on stockholders' equity is dictated by the type of dividend issued. When a company issues a dividend to its shareholders, the value of that dividend is deducted from its retained earnings.Even if the dividend is issued as additional shares of stock, the value of that stock is deducted. However, a cash dividend results in a straight reduction of retained earnings, while a stock dividend results in a transfer of funds from retained earnings to paid-in capital. While a cash dividend reduces stockholders' equity, a stock dividend simply rearranges the allocation of equity funds.

Cash Dividend Example

Assume company ABC has a particularly lucrative year and decides to issue a $8,000,000 dividend to its shareholders.

The stockholder equity section of ABC's balance sheet shows retained earnings of $12 million. When the cash dividend is declared, $8 million is deducted from the retained earnings section and added to the dividends payable sub-account of the liabilities section. The company's stockholder equity is reduced by the dividend amount, and its total liability is increased temporarily because the dividend has not yet been paid.

When dividends are actually paid to shareholders, the $8 million is deducted from the dividends payable subsection to account for the reduction in the company's liabilities. The cash sub-account of the assets section is also reduced by $8 million. Since stockholders' equity is equal to assets minus liabilities, any reduction in stockholders' equity must be mirrored by a reduction in total assets, and vice versa.

EFFECT OF ISSUANCE OF NEW SHARES

When companies issue additional shares, it increases the number of common stock being traded in the stock market. For existing investors, too many shares being issued can lead to share dilution. Share dilution occurs because the additional shares reduce the value of the existing shares for investors.

For example, let's say a company has 100 shares outstanding, and an investor owns ten shares or 10% of the company's stock. If the company issues 100 additional new shares, the investor now has 5% ownership of the company's stock since the investor owns five shares out of 200. In other words, the investor's holdings have been diluted by the newly issued shares.