Dividend Reinvestment Plan (DRIP)
A dividend reinvestment plan (DRIP) allows each common stockholder to use dividends to buy full or fractional shares of the firm’s common stock.
Thus, participating shareholders receive additional shares of company stock rather than getting cash. With a market plan, the firm uses the reinvested dividends to buy its outstanding shares in the open market for participating shareholders.
Firms often use a third-party trustee to buy these shares. With a new-issue plan, the firm sells new shares to participating shareholders.
Hence, the major difference between the two plans is the source of the share purchases.
Market plans involve only “old stock,” while new-issue plans involve newly issued or treasury stock. Another difference between the two plans is that a new-issue plan raises new capital for the firm, but a market plan does not.
Features DRIPs offer
Besides providing for the reinvestment of dividends, DRIPs offer other features. Most plans offer no or low transaction costs for buying shares.
Some plans offer a partial reinvestment option, the ability to make optional cash contributions, and open enrollment whereby anyone can buy the firm’s stock directly.
Others permit participants to have optional cash purchases electronically deducted from their checking or savings accounts. Plans sometimes offer stock at a discount from the actual market price.
Advantages of DRIPs
- From the perspective of a firm, DRIPs serve as a powerful mechanism to attract and develop shareholder loyalty.
- In addition, new issue plans provide a way to raise new equity capital and reduce a firm’s capital shortage problem.
- The chief disadvantage of DRIPs to the firm is administrative costs.
- From the participants’ perspective, DRIPs offer the advantage of building stock assets over the long term at a reduced cost.
- DRIPs typically do not charge annual, asset-based, or advertising management fees.
- In addition, DRIPs increase long-term investment returns by compounding an increasing dividend.
Disadvantages of DRIPs
DRIP investing has several disadvantages
- One drawback is the record-keeping needed to calculate share repurchases and costs to determine future taxable capital gains.
- Another disadvantage is that investors are subject to taxes because the IAS considers reinvested dividends taxable income.
- A potential drawback is that DRIPs trade shares on a specific date regardless of the market price.
- Finally, although some companies offer fee-free DRIPs, others stipulate transaction fees for purchasing and selling shares.