What is a Special Dividend?
A special dividend, also referred to as an extra dividend, is a non-recurring “one-time” dividend distributed by the company to its shareholders. it is separate from the regular cycle of dividends and is abnormally larger than a company’s typical dividend payment.
Special dividends are typically declared after exceptionally strong company earnings, the sale of a subsidiary or business unit, a business spin-off, or for achieving a company milestone.
Reasons for Paying a Special Dividend
A company pays out a special dividend for the following reasons:
1. Distributing extra cash available on the balance sheet
When there is too much cash available on a company’s balance sheet and it does not decide to reinvest the cash back into the business, the company may choose to distribute the cash in the form of a special dividend.
A prominent example is Microsoft’s special one-time dividend of $3 a share in July 2004, valued at a total payout worth $32 billion.
2. Altering a company’s financial structure
Recall the accounting equation Assets = Liabilities + Shareholders Equity. A special dividend can be used to alter a company’s capital structure by reducing equity and assets. By paying a special dividend, the company is altering the percentage of debt vs. the percentage of equity used to finance the company.
3. Instilling confidence in long-term value generation
Special dividends can be used by a company to show confidence in its long-term value generation and improve shareholder confidence. When shareholders receive extra cash in the form of a special dividend, they are more likely to stick with the company in the long term.
4. A hybrid dividend policy – Cyclical companies
Companies may use a special dividend in conjunction with their regular dividend policy to form a hybrid dividend policy. It can be seen with cyclical companies where they are largely affected by the economic outlook.
Cyclical companies may follow a normal dividend cycle and also declare a special dividend when the company is performing better than normal. It is better than increasing the dividend rate during economic booms or decreasing the rate during economic recessions, which may send mixed signals to investors.
Disadvantages of a Special Dividend
There are several disadvantages to consider when declaring a special dividend:
1. Perceived lack of investment opportunities
A special dividend can be seen by investors as the company finding no better use for its cash reserves. In other words, investors may see the company facing a lack of reinvestment opportunities. It may have a negative impact on the company’s stock price as investors may believe its growth potential is decreasing.
2. Opportunity cost of a special dividend
Companies may declare a special dividend only to realize that they do not have enough cash to fund future projects. Therefore, the opportunity cost of declaring a special dividend is high.
For example, consider a company that distributes its cash as a special dividend to investors. If an attractive investment opportunity were to arise in the future, the company might not have enough cash on its balance sheet to fund the project.
Impact of a Special Dividend on Share Price
Special dividends exert the same effect as a cash dividend on share prices. For example, consider a stock that is currently trading at $100 one day before the ex-dividend date. The special dividend declared is $20 per share.
Theoretically, on the ex-dividend date, the stock should decrease by $20 and trade at $80. With that said, the stock might be higher or lower than $80 on the ex-dividend date, depending on investor sentiment regarding the special dividend.
Journal Entries for a Special Dividend
The journal entries for a special dividend are the same as a cash dividend.
Consider a company that declares, on January 1, a special dividend of $1 per share on the 5,000 shares currently outstanding. The dividends are payable on February 1 to shareholders of record as of January 15.
Special dividends payable are $5,000 (5,000 x $1), and the journal entries are as follows:
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