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Series 7 Exam: Sharing Corporate Profits Through Dividends

The Series 7 exam expects you to know the forms of dividends an investor can receive and how the dividends affect both the market price of the stock and an investor’s position. If a corporation is profitable (and the board of directors is in a good mood), the board of directors may decide to issue a dividend to investors.

If and/or when the corporation declares a dividend, each shareholder is entitled to a pro rata share of dividends, meaning that every shareholder receives an equal proportion for each share that she owns. Although the investor can receive dividends in cash, stock, or property forms (stock of a subsidiary company or sample products made by the issuer). Cash and stock dividends scenarios are most likely to occur.

Investors can’t vote on dividends; instead, the board of directors decides dividend payouts. You can imagine that if this decision were left in the investor’s hands, they’d vote for dividends weekly!

Cash dividends

Cash dividends are a way for a corporation to share its profits with shareholders. When an investor receives cash dividends, it’s a taxable event. Corporations aren’t required to pay dividends; however, dividends provide a good incentive for investors to hold onto stock that isn’t experiencing much growth. Although cash dividends are nice, the market price of the stock falls on the ex-dividend date to reflect the dividend paid:

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Try your hand at answering a cash dividend question.

ABC stock is trading for $49.50 on the day prior to the ex-dividend date. If ABC previously announced a $0.75 dividend, what will be the next day’s opening price?

(A)    $48.25
(B)    $48.75
(C)    $49.50
(D)    $50.25

The correct answer is Choice (B). Check your work:

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The math’s as simple as that. Because stocks are now trading in pennies instead of eighths like they used to, calculating the price on the ex-dividend date is a snap.

Stock dividends

Stock dividends are just like forward stock splits in that the investor receives more shares of stock, only the corporation gives a percentage dividend (5 percent, 10 percent, and so on) instead of splitting the stock 2-for-1, 3-for-1, or whatever. Unlike cash dividends, stock dividends aren’t taxable to the stockholder because the investor’s overall value of investment doesn’t change.

The primary reason for a company to give investors a stock dividend is to make the market price more attractive to investors (if the market price gets too high, it limits the number of investors who can purchase the stock), thus adding liquidity (ease of trading) to the stock.

The following question tests your expertise in answering stock dividend questions.

Terry Trader owns 400 shares of OXX common stock at $33 per share. OXX previously declared a 10 percent stock dividend. Assuming no change in the market price of OXX prior to the dividend, what is Terry’s position after the dividend?

(A)    400 shares at $30
(B)    440 shares at $33
(C)    400 shares at $36.30
(D)    440 shares at $30

The answer you want is Choice (D). Here, you can find the answer without math. Because the number of shares increases, the price of the stock has to decrease. Therefore, the only answer that works is Choice (D). There is no guarantee that you’ll get a question where you don’t have to do the math, but don’t rule it out; scan the answer choices before pulling out your calculator.

Anyway, here’s how the numbers work. You have to remember that the investor’s overall value of investment doesn’t change. Terry gets a 10 percent stock dividend, so she receives 10 percent more shares. Now Terry has 440 shares of OXX (400 shares + 40 shares [10 percent of 400]). Next, you need to determine her overall value of investment:

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Because the overall value of investment doesn’t change, Terry needs to have $13,200 worth of OXX after the dividend:

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Terry’s position after the split is 440 shares at $30 per share.

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