Academic journal article Journal of Economics and Finance

Why Firms Adopt and Discontinue New-Issue Dividend Reinvestment Plans

Academic journal article Journal of Economics and Finance

Why Firms Adopt and Discontinue New-Issue Dividend Reinvestment Plans

Article excerpt

Abstract

We examine several arguments-past performance, capital structure adjustment, and broadening the ownership base-involving why firms adopt and discontinue new-issue dividend reinvestment plans (DRPs). We test hypotheses for each argument by analyzing financial characteristics for firms adopting and discontinuing new-issue DRPs compared with matching non-DRP firms. The evidence provides some support for the past performance argument but none for the capital structure adjustment argument. Limited support also exists for the broadening the shareholder base argument. Overall, the results support the notion that firms needing funds initiate new-issue DRPs, and then discontinue them when the need for external funding diminishes. (JEL 6320 and 6350)

Introduction

In a dividend reinvestment plan (DRP), the participating company provides its shareholders with an option to use the announced dividends either to receive the payment in cash or use the amount to purchase additional shares. Initially, all DRPs were market plans in which a company buys its outstanding shares in the open market and then sells them back to its shareholders at low or no commission cost. In the early 1980s, utilities introduced new-issue plans, in which the firm uses either authorized but unissued shares or treasury shares to provide stock to those investors choosing to reinvest their dividends. Thus, new-issue plans provide a source of additional equity to the firm in the form of reinvested dividends.1

As time passed, non-utilities too began to offer new-issue plans. Additionally, companies added many new features to their DRPs (Baker and Johnson 1988a; Baker and Meeks 1990). Perhaps the most noteworthy feature is the voluntary purchase option that allows stockholders to make additional investment beyond the dividend amount toward purchases of shares. Other features include no commissions and a discount, which allows shareholders to apply dividends to buy additional shares, usually at a 5 percent discount from the market price. Companies use these two features to compensate investors for the tax penalty on reinvested dividends. That is, DRP participants must still pay taxes on the dividends, even though they receive shares in lieu of a dividend. Today, hundreds of market and new-issue plans continue to coexist (American Association of Individual Investors 2001).

Although much research exists on DRPs, researchers have not addressed several important questions. The purpose of this study is to investigate two previously unanswered questions involving new-issue DRPs. First, why do some firms in the same industry and with similar size offer new-issue DRPs, while others do not? Specifically, we examine three arguments for why firms adopt new-issue DRPs: the better past performance or higher future growth argument, the capital structure argument, and the broadening the shareholder base argument. Identifying distinguishing financial characteristics of firms that adopt DRPs is important because several empirical studies show that the market reacts favorably to the adoption of DRPs.2 Second, why do some firms abandon their new-issue DRPs? That is, have new-issue DRPs outlived their usefulness to these firms? To investigate these questions, we compare the financial characteristics (representing the same three arguments) of new-issue DRP-discontinuing firms with those of a group of matching non-DRP firms.3

Although several past studies focus on determining the characteristics of firms with DRPs and the features of such plans, most focus on market plans. In our study, we examine new-issue plans and try to determine the financial characteristics relating to adopting and discontinuing these plans. This study should be useful to three groups-academic researchers, financial managers, and investors. First, the study provides evidence about several research questions involving new-issue DRPs not previously addressed in the academic literature. …

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