Dividend Reinvestment Plan – Definition

Cite this article as:"Dividend Reinvestment Plan – Definition," in The Business Professor, updated November 24, 2018, last accessed October 27, 2020, https://thebusinessprofessor.com/lesson/dividend-reinvestment-plan-explained/.


Dividend Reinvestment Plan Definition

A Dividend Reinvestment Plan (DRIP) is a plan that allows investors to reinvest their dividends into additional shares or fractional shares. The shareholders receive dividends from the companies periodically. It is a share of the companyā€™s revenue which they receive as cash (cash dividends). Companies offer the shareholders to invest that amount to buy more shares of the company on the dividend payment day.

A Little More on What is a Dividend Reinvestment Plan

In common practice the shareholders are paid the dividends either by check or the amount gets directly deposited to their bank accounts. The shares offered in a Dividend Reinvestment Plan or DRIP are generally from the companyā€™s reserve and are not marketable through stock exchanges. The shareholders use the dividend value to purchase these shares.

A dividend is taxable whether received or reinvested. An individual must report the dividend while filing the tax-return even when he does not receive the amount in cash and reinvests it into additional share.

A DRIP enables the shareholders to acquire more shares at a lower or discounted price. They do not have to pay the commission for buying the share. Also, companies generally offer a 1% to 10% discount on the market price. Automatic reinvestment compounds the return. As time goes by, one’s share increase in the company and that results in more dividends, so in the next quarter, they can buy even more shares with it. This provides an opportunity to earn a greater return in long-term.

The shares sold in DRIP are less liquid than share offered in the open market. So, when the stock market declines it is less likely that the shareholders sell these shares. Also, the participants in a DRIP generally aim for a long-term return, thus they do not sell their shares during market volatility. This is one of the reasons the companies prefer the Dividend Reinvestment Plan.

References for Dividend Reinvestment Plan

Academic Research on Dividend Reinvestment Plan

Decentralized investment banking: The case of discountĀ dividendreinvestmentĀ and stock-purchaseĀ plans, Scholes, M. S., & Wolfson, M. A. (1989). Journal of financial economics,Ā 24(1), 7-35. This paper explained the stock purchase plans as well as the discounted dividend-reinvestment plan which gives shareholders the opportunity to control part of the underwriting fees acquired in new stock offerings thereby saving the sponsoring firms the stress of the usual underwriting costs estimation. According to this study, the rate at which individual investors profitably serve their investments banking function was explained. However, this process is achieved by implementing a simple trading and or investment strategies which have been particularly designed to capture the discounts and share the leftovers (shares) in the market.

The Adoption of Newā€IssueĀ Dividend Reinvestment PlansĀ and Shareholder Wealth, Peterson, P. P., Peterson, D. R., & Moore, N. H. (1987). Financial Review,Ā 22(2), 221-232. In this paper, tests were carried out as regards the process of securities and their reactions to the implementation of the new-issue dividend reinvestment plans. According to this research paper, the research sample methodology used was broken down into three subsamples which include the utilities adopting plans prior to May 1981, non-utilities and the utilities adopting plans after July 1981. These subsamples were carefully explained in this research paper as well as their correlation with the shareholderā€™s wealth.

TheĀ dividend reinvestment planĀ puzzle, Bierman, H. (1997). Applied financial economics,Ā 7(3), 267-271. According to this research paper, a wide variety of plans was said to exist but the typical (real) plan has no transaction cost for the investors. However, this paper argues that some plans offer discounts on prices from the market but the main bone of contention (problem) is ā€œWhat is the main purpose of the dividend reinvestment plan? Does ignored tax have any effect on the dividend policy of a firm? All these questions and arguments were explained in this paper and justifiable conclusion was reached. Although, most corporations that have the capacity to pay dividend pay them, in some scenarios, a dividend payment might reduce the rate/transaction cost incurred by investors who are willing to increase cash flow from the firm.

Tax incentives and capital structures: The case of theĀ dividend reinvestment plan, Chang, O. H., & Nichols, D. R. (1992). Journal of Accounting Research, 109-125. In this research paper, the capital structure and tax incentives were practically discussed. This paper, however, uses the scope of the dividend reinvestment plan to explain the aforementioned (Tax incentives and Capital structure).

An Optionā€Theoretic Approach to the Valuation ofĀ Dividend ReinvestmentĀ and Voluntary PurchaseĀ Plans, Dammon, R. M., & Spatt, C. S. (1992). The Journal of Finance,Ā 47(1), 331-347. According to this research paper, the purchase price for the newly-issued shares most times is determined by the stockā€™s price average over a period of time which precedes the investment date. This process thus gives the firmā€™s shareholder an edge to invest more in share when the stock price becomes greater than the calculated average price. This paper, however, explains that several firms with dividend reinvestment plans also give their shareholders the opportunity to willingly invest additional funds that can be used to incur supplementary shares. Both the numerical and theoretical method was adopted to explain the value of these willing purchase options in practice and theory.

AutomaticĀ dividend reinvestment plansĀ of nonfinancial corporations, Pettway, R. H., & Malone, R. P. (1973). Financial Management, 11-18. This paper explains the rate at which the use of the automatic dividend reinvestment (ADR), the costs, advantages, disadvantages and operations are involved. This study argues that there is an increase in the rate at which the number of the nonfinancial corporations allows stockholders to directly reinvest their dividends. Thus, this paper developed a profile which will help to differentiate the industrial ADR users from the non-users. Hence, the aim of this study is to explain the automatic dividend reinvestment plans of the non-financial corporations. Information gotten from a survey of the S&P from 500 different firms gives an insight into the stockholder’s acceptance of these plans

OnĀ dividend reinvestment plans: The adoption decision and stockholder wealth effects, Hansen, R., Pinkerton, J., & Keown, A. J. (1985). Review of Financial Economics,Ā 20(2), 1. This paper explains the on dividend reinvestment plans by explaining the adoption of the decision and the effect of the stockholderā€™s wealth.

Dividend reinvestment plansĀ as efficient methods of raising equity financing, Roden, F., & Stripling, T. (1996). Review of Financial Economics,Ā 5(1), 91-100. This academic paper presents the result gotten from the test carried out on the effect of establishing the dividend reinvestment plans via public utilities. According to this study, various questionnaires were mailed to a sample of public utilities which helped to establish the dividend reinvestment plans before May 1981 and made use of the event methodology to estimate the excess returns that surrounds the announcement dates of plans. However, analysis carried out in this study shows statistically that a significant and positive average excess returns within the space of 15 days precede the announcement. Hence, this paper explains the efficient methods of raising equity financing.

New issueĀ dividend reinvestment plansĀ and the cost of equity capital, Finnerty, J. D. (1989). Journal of Business Research,Ā 18(2), 127-139. This paper explains that the cost of equity capital gotten from the newly issued dividend reinvestment plans is higher than the cost of the retention-financed equity capital but lower than the cost of the stock-financed equity capital especially when shares are sold via the New issued dividend reinvestment plans at their market value. However, this process results in a transfer of wealth from nonparticipants to participants which later raise the cost of the NIDPR-financed equity capital. Hence, this paper explained the relationship between the new issue dividend reinvestment plan and the cost of equity capital.

Australian tax changes andĀ dividend reinvestmentĀ announcement effects: A pre-and post-imputation study, Chan, K. K., McColough, D. W., & Skully, M. T. (1993). Australian Journal of Management,Ā 18(1), 41-62. This paper adopts the use of an event study approach to explain the effect of the dividend reinvestment plan on shareholders return especially I the pre and post imputation environment. Although the daily share return behaviours show that the announcement as regards when and how to introduce the DRP was received, it was received indifferently by the market prior to the imputation; however, it later became positively valued. The result gotten from this paper supports the suggestion that the imputation of the optimal dividend policy is meant to implement a DRP in other to retain cash flow and share the maximum franked dividend.

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