Cash Dividend or Stock Dividend?

The flashy billionaire Elon Musk is stirring up waves again. After challenging Russian President Vladimir Putin to fisticuffs for the fate of Ukraine last month, Musk is purportedly trying to buy Twitter (NYSE: TWTR) and take the social media platform private.

Musk also hinted that his electric vehicle maker Tesla (NSDQ: TSLA) is looking to get into the lithium business, probably by buying up a lithium producer. What’s more, Tesla wants to pay a stock dividend to shareholders, pending shareholder approval at the company’s annual meeting later this year.

However, this so-called dividend works more like a stock split. For example, if you held 100 shares of XYZ worth $50 each, after a 2-for-1 split you will have 200 shares worth $25 each. The total value of your position remains the same, $5,000 (100 x $50 or 200 x $25).

To pay the stock dividend, Tesla will have to issue additional shares. This increases the number of shares outstanding and dilutes the value of existing shares.

TSLA shareholders will get more TSLA shares, but the value of each share will likely fall, since there will be more outstanding shares after the dividend. In effect, that’s what happens in a stock split. The difference is that there’s no automatic adjustment in stock price. How much the price adjusts downward will depend on the market.

Benefit of Deferred Taxation

The benefit of such a dividend is that it’s likely not taxable until you sell the shares. This allows you to enjoy (hopefully) the future gains from the stock without taxation. But if you want to convert the shares into cash, you will need to sell and trigger capital gains (in a taxable account).

Depending on your tax bracket, capital gains tax may or may not be lower than the normal dividend tax. The other benefit is that with the stock price lower, the stock may look more appealing to retail investors, which could attract additional buying interest and lift the stock price.

It appears as if TSLA shareholders won’t have a choice, but sometimes, a company will offer you the choice between receiving cash or receiving shares at a predetermined ratio. Which should you choose?

Cash or Stock?

The first step is to calculate which offer is worth more.

For example, let’s say you own 100 shares in a hypothetical company called XYZ. The stock is trading at $20. The company offers you a choice between receiving $0.50 per share in cash or 0.26 shares per share held.

The cash dividend is worth $50 (100 x $0.50). Since you have 100 shares, you will receive 26 shares of XYZ. And at XYZ’s current price of $20, the 26 shares would be worth $52 ($20 x $0.26).

Thus the share offer looks more attractive. However, the stock price changes over time, so by the time you actually receive the stock dividend, the value of the shares received will likely be more or less than $52.

It’s a good deal if XYZ moves up in the interim, but if the stock instead went down, it becomes a raw deal. For this reason, some investors prefer the sure thing of the cash dividend, knowing just how much they will get.

As mentioned earlier, dividends received in the form of stock usually aren’t taxable until sold, but if the offer comes with a cash dividend option, the dividend is treated as taxable income even if you don’t sell the stock. In this hypothetical XYZ scenario, the tax advantage of a stock dividend doesn’t come into play.

Basically, unless there’s a huge difference between the cash and stock, the choice comes down to whether you prefer the sure thing of cash or you want to take a chance that the stock will do well.

Since you own XYZ, presumably you are bullish on the stock. Thus, choosing the stock dividend and hoping the share price rises isn’t the worst thing. However, if you are risk averse, the cash option probably makes more sense for you.

Your outlook on the direction of the market also matters. For example, if you expect the market to rise, you should take the shares. If you expect the market to fall, you should take the cash.

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