Payout policy is an important component of a firm’s ability to maintain financial flexibility. Given the market’s heavy penalization of reductions in the dividend payout level, financially constrained firms must find ways to retain cash when cash reserves are insufficient to cover future investment needs. In this context, elective stock or scrip dividends provide a way for financially constrained firms to preserve cash by offering shareholders the choice between receiving a cash dividend or the equivalent value in newly issued company shares. Shareholders who choose new shares do not receive cash but avoid a dilution of their ownership stake following the issue of the new company shares, whereas shareholders who prefer cash experience dilution.
By means of a broad range of proxies for financial constraints and access to finance for a UK sample of LSE-listed firms, we show that financially constrained firms use scrip dividends to maintain their financial flexibility. In periods with reduced access to external financing, firms are also more likely to introduce scrip dividends. Using the financial crisis in 2008 as an exogenous shock to external credit supply to mitigate endogeneity concerns, we confirm that financial constraints are strongly positively related to the use of scrip dividends. The relation between financial constraints and scrip dividends is stronger for younger and smaller firms, which may have limited access to external finance. We further show that scrip dividends are positively related to increased future cash needs: scrip dividends are more likely to be used by firms that have recently done or intend to do a debt-financed M&A, as such an investment increases the cash drain related to servicing the debt.
When we investigate the relation between scrip dividends and dividend cuts, we document that scrip dividends are more likely to be used in combination with a reduction in payout. This suggests that scrip dividends are complements to dividend cuts rather than substitutes, although we do not find that the market is fooled by combining scrips and cuts: the market reactions are significantly negative for scrip dividend reductions, especially when the firm had already been paying scrip dividends before. To test the robustness of our results, we investigate elective stock dividends in the US in the form of DRIPs. Similar to UK-style scrip dividends, DRIPs that involve to new share issues or treasury shares are offered by more financially constrained firms.
Overall, this study provides evidence that the use of scrip dividends strongly supports the cash retention hypothesis.