Freeman Plumbing Supplies has decided to reexamine its existing dividend policy, which was established 30 years ago when the firm first started paying dividends. Freeman’s operations have changed significantly during the past 30 years, so the CEO wants to determine whether its dividend policy is still appropriate.
The CEO suggested that tit might be a good idea for the firm to begin a dividend reinvestment plan (DRIP) because he believes that the company is a good investment and that most of the firm’s stockholders would prefer to have their dividends reinvested in the company’s stock rather than paid to them in cash. As a result, Ed Davidson, one of Freeman’s most experienced financial managers, was assigned the task of evaluating the feasibility of starting a DRIP program.
It is Ed’s opinion that Freeman should pay dividends to maintain its market value and, thus, also maintain stockholders’ wealth. Since the tax rate on dividends was lowered a few years ago, most companies in Freeman’s industry have either increased their dividends or started paying dividends for the first time. So Ed is convinced that Freeman must continue to pay dividends; in fact, he thinks that the amount of dividends should be increased.
When Ed was assigned the task of evaluating the possibility of starting a DRIP program, he was excited. He knew that the program would be administered in his department, which would give him and his colleagues a chance to showcase the quality of work they perform. As his evaluation progressed, however, Ed started to get concerned that the CEO had a personal ulterior motive in mind when he suggested the DRIP program. Ed’s concerns increased when he found out that Freeman’s executives receive huge bonuses each year that are normally paid in the form of the company’s stock. His research indicates that a DRIP program would permit executives to receive their bonuses in the form of dividends that are reinvested in company’s stock, which would have the same effect as the existing bonus-payment system. However, because they actually receive a dividend payment, the executives would be taxed differently if their bonuses “pass through” a DRIP program. If executives are paid their bonuses using the existing plan, any stock they receive is taxed at the same rate as their ordinary, or “regular,” income, whereas qualified dividends are taxed at lower rates. In other words, stock that is purchased through a DRIP plan qualifies as a dividend payment that would be taxed at a more favorable rate than ordinary income.
With the additional information that he has collected, Ed is concerned that the CEO wants to initiate a DRIP program only because it will be beneficial to Freeman’s executives. Although Ed is still in the beginning stages of his evaluation, he doesn’t think the company should initiate programs just because they benefit executives. At this point, Ed is trying to decide whether he should abandon his evaluation and tell the CEO to “go jump in the lake” or continue with an evaluation that might give the CEO the justification he needs to start a program that will benefit top management.
What should he do? What would you do if you were Ed?