Special Dividend

A special dividend is a rare, non-recurring payment given out by a company to its shareholders.

These dividends are generally independent of the traditional dividends and are very large compared to a normal dividend payout.

This kind of dividend payout is declared when the company has either reported very strong earnings, sold a business unit, or achieved a milestone.

A company pays out this kind of dividend for the following reasons:

1. Distributing extra cash available on the balance sheet

If a huge sum of cash is lying on the company's balance sheet and there is not currently a project to invest that money into, it can declare a special dividend to increase shareholder profits.

For example, after the sale of a subsidiary, Griffon announced a special $2 dividend on top of their normal quarterly $0.09 dividend.

2. Altering a company's financial structure

Remember the equation, Assets = Shareholders' Equity + Liabilities, from high school? This kind of dividend is used to modify a company's capital structure. This is done to alter the ratio of debt and equity in the company's total capital.

3. Instilling confidence in long-term value generation

This kind of dividend is a method through which management can instill confidence into investors that the company will do well in the future. Investors are more likely to hold onto a stock for longer periods if they receive cash in the form of these dividends.

4. A hybrid dividend policy – Cyclical companies

A hybrid policy can also be formed by paying out special dividends along with regular dividend payments.

This is usually seen with companies operating in a cyclical industry; they are affected by the whole economy's performance. These companies normally follow a traditional dividend policy and declare a special dividend during the peak season of their earnings.

This is a better way to declare dividends than high dividends during booms and no dividends during recessions as it instills confidence in investors about a company's stability due to reduced volatility of its dividend payout ratio.

Advantages & Disadvantages 

There are possible disadvantages to consider when declaring this kind of dividend:

1. Perceived lack of investment opportunities

Declaration of a special dividend can impact a company's stock price, as investors might view the declaration as an admission of a lack of investment opportunities with the company. This may signal a reduced growth potential, resulting in a panic amongst investors.

2. Opportunity cost

Sometimes, companies declare a special dividend and later realize they do not have sufficient cash to fund future investment opportunities. Therefore, the opportunity cost is very high when declaring a high dividend.

Companies that declared this dividend might have to let go of certain projects just because, at the right moment, they did not have the cash on their balance sheet due to having paid a huge dividend.

Some advantages to consider when declaring this kind of dividend are: 

1. Increased Market Value

Declaring this kind of dividend would increase a company's market value, that is, the market value of a company's share rises sharply after the announcement of such payment.

2. Shareholder Expectations Fulfilled

If a company declares such a dividend, it generally would mean it has satisfied its shareholders' needs and provided them with the required return on their investment.

Impact of a Special Dividend on Share Price

The dividend affects the share price similarly, whether it is a special or a traditional cash dividend. 

For example, let's say a stock X was priced at $300 before the ex-dividend date (the last day a buyer can purchase shares and receive dividends). A $30 special dividend was previously declared by the company. 

Theoretically, the stock should fall by $30 on the ex-dividend date and trade at $270; however, the stock might actually differ from $270. This is because stock prices factor in investors' opinions about the special dividend and what it implies about the company's health.

Since the effect of special and normal dividends are the same, the journal entries are also the same for both of them. 

Let's say there is company X declares a special dividend of $2 per share on April 1, with 50,000 shares outstanding. The record date is the 20th of April, and the payment date is the 10th of May.

Total dividends to be paid are $100,000 (50,000 x $2), for which journal entries are as follows:

Special Dividends and Traditional Dividends

A special dividend is non-recurring and happens very rarely. However, traditional dividends are announced quite frequently, such as quarterly or annually. The company's board of directors decides the amount given out in dividends.

It can be reflected in the stability of dividend policy, payout ratio, etc. For example, software companies report negative cash flows in their early stages and must reinvest the money earned in later years to expand their operations.

Companies with high growth prospects generally do not pay dividends as they need to reinvest into their business. On the other hand, a relatively stable and mature company operating in the fast-moving consumer goods (FMCG) industry, for example, would declare a regular dividend with the aim of shareholder return maximization.

Real estate investment trusts and master limited partnerships generally pay a high amount of dividends. Companies declaring a huge dividend indicate to their investors that they can sustain operations without keeping huge amounts of cash on their balance sheets.

Researched and Authored by Kunal Goel | Linkedin

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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