Dividend Reinvestment Plan - Assignment Example

Question 1 i. Dividend Reinvestment Plan (DRIP) Definition “Dividend Reinvestment Plan/Program or DRIP refers to a plan that is offered by a company to its shareholders for reinvesting their cash dividends by buying additional number of shares on the date of dividend payment.” Explanation One of the biggest stumbling block standing in the way of investors to invest in shares is ‘money’. Nevertheless, a way has been found out to invest in shares and to expand a portfolio over the period without incurring large amounts of fees using Dividend Reinvestment Plan (DRIP). Dividend Reinvestment Plan (DRIP) is an admirable approach to increase the value of one’s investments. Most corporations allow a shareholder to purchase shares commission free or at a substantial discount to the prevailing share price in market. Most corporations do not allow reinvestments lower than $10. Through DRIP, shareholder can accumulate more shares without paying commission to broker (Collins, 2010). How it Works? At this point of time, over 1000 companies are offering DRIPs. The reason is simple, this plan allows people to purchase more of the company’s stocks because dividends are reinvested into the company knowing that more of the shares will be bought and will likely be held for a longer tenure. When a shareholder registers for Dividend Reinvestment Plan, he no longer receives the amount of dividend deposited directly into his brokerage account or delivered through mail. Instead of that, that amount is used to buy additional number of shares of the corporation. This approach is in favor of investor because one can enjoy the comfort of investing by spending just a little amount and having no commissions to pay and therefore, the investor will be having the best and biggest stocks, which the market has to propose (Collins, 2010). Companies Offering Dividend Reinvestment Plan A lot of large multinationals are offering Dividend Reinvestment Plans. Some of them include: Coca Cola Co 3M Co Exxon Mobil General Elec Co Johnson and Johnson Tim Horton’s Pfizer Inc Pepsi Co Procter and Gamble Duke Energy Home Depot Inc (DRIPInvestingorg, n.d) Quarterly Dividend Payment Quarterly Dividend Payment = Annual Dividend Payment No. of Quarters in a year Quarterly Dividend Payment = 2.2 4 Quarterly Dividend Payment = £0.55 each quarter ii. Number of New Shares from Dividend Payout Calculation for number of new shares which can be bought from the dividend payout amount has been shown in the table below. Number of New Shares = Number of Current Shares * Dividend Payout Annually Price Per Share Number of New Shares = 805,000* 2.20 35 Number of New Shares = 1,771,000 35 Number of New Shares = 50,600 Shares If Mr. Adams accepts the advice of his Financial Advisor, he would have accumulated 50,600 additional shares. iii. Advantages and Disadvantages of Dividend Re-investment Plan (DRIP) When the markets are performing well, investors do not seem to purchase enough shares to appease their appetite. This statement seems logical but there is another fact that stock markets are the most reliable and stable investment option as far as long term investment is concerned. Companies desire the option of DRIP for it allows them easy access to capital at lower rate of interest (Motley Fool, n.d). Advantages A large amount of money is not required to start and therefore usually one share possession is required to register in DRIP. DRIPs are considered as the most cost effective way for investors to put their stock dividend to better use. Most DRIPs allows reinvestment of dividend at no fees at all (Motley Fool, n.d). Some companies charge nominal fees to allow investors to buy additional stocks through DRIPs while others charge no fees at all. These types of stock purchase provision are called as Optional Cash Purchase (OCP) or Stock Purchase Plans (SPP). They require an investor to send fees ranging from $10 to $50 at the time of buying additional shares. A large number of companies nowadays allow investors to buy shares at discount to the existing market price. These discounts usually range from 1% to 10% (Investopedia, 2011). DRIPs force shareholders to either purchase stocks on consistent basis or hold on to that share. Consequently, shareholders embrace a long-term approach towards investing and frequently invest small amounts of money consistently. Therefore, in DRIP shareholders are more likely to not only retain their shares, but also purchase more (Kennon, n.d.). Disadvantages People like to realize that their investments are growing until they are ready to make a large purchase or to get retirement; sometimes it is important to liquidate so as to meet the current requirements. Unfortunately, it is not easier to liquidate the Dividend Reinvestment Plan. In this case, it is required to directly contact the company in order to get exit from the plan or to sell the accumulated shares. Another problem with Dividend Reinvestment Plan is that they are on their own. Since there is no fee for brokers in DRIPs, therefore there is no broker involved in this plan to guide investors about making investment decisions. It is all up to the shareholders to research and investigate potential companies and their respective DRIPs. Therefore, such plans carry a large amount of risk for novice investors. Though DRIP makes it more intricate to liquidate the stock, therefore more homework is required on the part of investor (Kennon, n.d.). Advantages of DRIP make them more attractive towards novice investors. Such plans may relinquish the cash dividend payment to investors but allow building up a substantial stake in the corporation over the period of several years. Equity markets on an average have been providing an annual return of 11% which is why, long term investors tend to get better margin of returns as compared to short term investors. iv. Alternative Plan Dividend Reinvestment Plan is primarily designed for those investors which prefer staying in a single stock for a long period of time. DRIPs demand a very long term commitment and therefore many people don’t trust a single company to perform well for next 30 years. It is like keeping all your eggs in one basket. DRIP is healthy for risk-averse investors which prefer in keeping one stock till their retirement. Portfolio Diversification First alternative plan for DRIP is Portfolio Diversification. Instead of buying a large numbers of shares of a single company, one must diversify his investments by keeping some proportion in stocks, some in bonds, some in gold and other commodities and some in currencies. It will help in minimizing the risk which an investor can confront by investing a large sum of money in a single investment. Low Cost Mutual Fund Another alternative for DRIP is Low Cost Mutual Fund. Instead of investing dividend payout in the same stock, one can invest in companies like TIAA-CREF or T. Rowe Price that diversifies the amount of investment across hundred companies. Both of the above mentioned options are types of portfolio diversification therefore, in short the only best possible option available for DRIP is diversifying own portfolio. It is essential to consider alternative plans for DRIP so that after evaluating pros and cons, one can take a better investment decision. Question 3 i. Distinguish between the price/earnings (P/E) ratio and the earning per share EPS ratio. Price-Earnings Ratio (P/E Ratio) Price-Earnings Ratio values the current share price of the company to its earnings per share. It can be calculated by the following formula: Price-Earnings Ratio (P/E Ratio) = For instance, if a company’s share is currently trading at $50 per share and company’s earnings for the past 6 months were $2.05 per share, then the P/E ratio of that share would be; Price-Earnings Ratio = = 24.39 For this formula, the EPS that is used in the formula is usually from the last 12 months. However, sometimes it can be taken from the projected earnings of the next 12 months, i.e. forward or projected P/E. P/E Ratio is also called as Earnings Multiple or Price Multiple. Generally, a high P/E Ratio tells that stockholders are expecting higher growth in earnings in future as compared to stocks having low P/E. Despite of that, P/E Ratio cannot tell the entire story and therefore, it requires comparing the P/E ratio of different companies belonging to the same industry in order to compare and evaluate the position of the company. Earnings Per Share (EPS) This ratio determines the proportion of profit of company allotted to outstanding stocks of the common stock. This ratio defines the profitability position of the company in terms of each share. It can be calculated by: EPS = EPS is usually considered as the single most considerable variable in determining the share price of the company. It is also the key constituent in determining P/E Ratio. For instance, a company has net income of $30 million. If $1 million are paid as dividends to preferred shareholders and has 5 million shares in the first six months and 7 million shares in the other 6 months, the EPS can be calculated as; EPS = = = $4.83 Since the numbers of outstanding share over the period of 12 months, do not remain constant, i.e. sometimes companies offer new shares, therefore weighted average is calculated to find out the number of outstanding shares. It can be calculated by: Weighted Average Number of Outstanding Shares = 0.5 x 5m + 0.5 x 7m = 6m The higher the EPS, the better the company is performing. Therefore, investors are usually looking for companies having higher EPS. Despite of that, the manipulation in earnings can cause misleading figures of ratios therefore investors need to use financial measures in conjunction with other financial measures or statement analysis. ii. “Discuss the importance of a share with a relatively high price/earnings ratio to a personal investor”. P/E ratio is considered as one of the important aspects which a personal investor must take care of. The reason behind its importance is that a specific share with a high P/E ratio provides the likely increase in the share price given the earnings of that stock as compared to the one which has relatively low P/E ratio. High P/E ratio provides more opportunities to a personal investor for a particular increase in the share price. Low P/E ratio tends to lower the share price a bit even if it has the same EPS as that of the one having high P/E ratio stock. Question 4 i. “Investing on shares traded on Stock Market poses serious risks to its participants. This is so because of the inherent instability in the markets. Identify two of these risks and explain how an investor can manage these risks”. Risks of Stock Markets Undoubtedly, investing in stock markets poses serious risks to investors. A lot of risks are associated with the investment in equity markets which include economic risks, default risk, industry specific risk etc. Two major risks associated with stock markets are: i. Default Risk The biggest risk for investors of investing in stock markets is default risk of the company in which they are investing. There has been many events seen in which the company gets unable to make payments to its investors and lenders and therefore, bankrupts and all the investments of shareholders are drown. This risk is solely associated to the company and no other company gets impact of this risk. ii. Industry Specific Risk As explained by its name, industry specific risk is primarily associated with the immediate industry within which companies are performing. For instance, if a country experiences recession in its housing and real estate sector, then all the companies associated with this sector will experience decline in their earnings, share price etc. Housing and real estate sector can cause decline in industries such as cement industry, steel industry, glass industry etc. Managing Risk Large number of risks that are associated with stock markets can never be eliminated completely but by implementing good strategy and taking smart decisions, to certain extents these risks can be minimized. The primary reason due to which investors make stock markets more risky is that they don’t go for diversifying their investment. The best option available to minimize these risks is Diversification. Long term investing and diversification strategies help in gaining best possible return at lowest possible risks. For both default risk and industry specific risks, diversification is the best option. Investors need to diversify by buying stocks from not only different companies, but also from different industry so that slump in a specific industry does not sink the entire investment. Works Cited Kennon, J., n.d. Dividends 101 - The Beginner's Step-By-Step Overview of How Dividends Work. [online] Available at: [Accessed 31 March 2013]. Investor Guide, 2013. Advantages and Disadvantages of Dividend Reinvestment Plans. [online] [Accessed 31 March 2013] Motley Fool, n.d. What Are Dividend Reinvestment Plans (DRPs)? [online] [Accessed 31 March 2013] Collins, J., 2010. How Dividend Reinvestment Plans (DRPs) Work. [online] [Accessed 31 March 2013]. Investopedia, 2011. The Perks of Dividend Reinvestment Plans [online] [Accessed 31 March 2013] The DRiPs DRiPpers DRiP Results for 2007, n.d. [online] [Accessed 31 March 2013] Read More