Why Do Firms Issue Stock at a Discount? Dividend Reinvestment Plans: Shareholder Wealth and Capital Accumulation
Swartz, L. Mick, Journal of Global Business Issues
A dividend reinvestment plan with a discount sells shares cheaper than the market and incurs costs and possible loss of value for the firm. The empirical evidence supports the hypothesis that investors in these companies temporarily earn negative returns consistent with an increase in costs and then earn positive abnormal returns over a longer time period. These returns are generated by two sources; one source is the increase in future profitable opportunities signaled by the firm and results in a persistent positive abnormal return. The other source occurs at the initial onset of the DRIP when investors see a slight decrease in the share prices over the first month. Firms with larger discounts experience a larger decrease in abnormal returns initially. The longer-term positive abnormal returns exist even prior to the discount being taken into account. Evidence is provided that indicates the motivation for the firm to implement a DRIP is to acquire additional capital, this lasts more than two years. If the explanation for a DRIP is merely convenience, cost or investment banking fee related then we should not observe persistence in positive abnormal returns.
Dividend Reinvestment Plans or DRIPs, as they are commonly called, have not been studied in the academic literature very extensively. In fact, there are no previous empirical papers on the subject. Dividend Reinvestment Plans are programs companies put into place for shareholders to accumulate more shares directly from the company. The normal procedure of buying shares through a broker is bypassed and the shareholder buys additional shares directly through the company; using dividends that would have been paid to the shareholder to automatically purchase additional shares of the company stock. By requiring stockholders to hold the shares in their own name the liquidity of the asset is slightly altered. Stockholders do not hold the shares in street name and must deliver shares to a broker to sell. This could affect the probability or timing of the sale of these securities. You could argue there is a slight loss of liquidity for the shareholder.
Some firms issue no discounts for automatically purchasing additional shares through the dividend reinvestment plan. Some companies issue small discounts ranging from one to two percent of the value of the shares. A few companies will issue discounts greater than five percent. The shareholders save money on brokerage commissions and the firm attracts some capital without paying investment-banking fees. Does this save the firm money and is it successful at attracting additional capital for the firm ? In addition, do investors earn abnormal returns ? If the program has costs, does the shareholder pay for these costs with lower shareholder returns ?. If a company does not have future profitable opportunities, then there is no reason to attract additional capital. If there are potential profitable projects, then the firm may attempt to signal these opportunities by implementing a DRIP, offering incentives, and sharing the rewards with the "new" shareholders. That is, those investors who invest additional capital through the DRIP are rewarded with excess returns. If the project is successful enough, then the company will be able to allow discounts, thereby attracting more capital, and still earn the rate of return necessary to meet shareholder required return expectations.
The academic literature on DRIPs is nonexistent. However, the incentive, agency cost and signaling literature would still provide a framework to study this area. If firms save money-obtaining capital, it would be rational for firms to give incentives to shareholders that are participating in these DRIPs. If the money saved is relatively small then it is possible that the firm does not give incentives or discounts, but merely provides the DRIP as a shareholder convenience. The DRIP may save money on the capital it obtains, however there are costs. …