What is a Capital Dividend
A capital dividend, also known as a 'return of capital,' is a type of payment a firm makes to its investors that is drawn from a company's paid-in-capital or shareholders' equity, rather than from the company's earnings as with regular dividends. A company will generally pay a capital dividend in instances where a dividend payment is required, but company earnings cannot facilitate such cash payment.
BREAKING DOWN Capital Dividend
A capital dividend is typically not taxable for shareholders, as it is viewed as a return of the capital that investors pay in. Capital dividends are not a preferred form of dividend payment for firms or investors, as they often indicate a company’s struggling to generate earnings and free cash flow. Additionally, by paying out dividends from retained earnings, a company's struggles may worsen as its capital base shrinks, limiting investment and business opportunities in the future.
Capital Dividend and Regular Dividend Payment
A capital dividend and a traditional dividend differ in that a traditional dividend is distributed from a company's earnings. Traditional dividends may be issued as cash payments, shares of stock, or another form of property. A company’s board of directors (BoD) decides on the timeframes (generally monthly or quarterly) and payout rates for traditional dividends. A board may also distribute special dividends separately or together with a traditional, scheduled dividend.
Dividends are a form of reward for shareholders’ purchasing a stake in a company. Dividend payments usually indicate that a company is established and has consistent free cash flow. For this reason, start-ups and other high-growth companies rarely offer dividends, preferring instead to put any profits back into research and development to continue higher-than-average expansion. Startups, particularly in the technology sector, often report losses in their early years.
In contrast, larger, more established companies consistent and predictable profits often pay the best dividend. Such companies, historically in basic materials, oil and gas, banks and financial, healthcare and pharmaceuticals, and utilities tend to issue regular dividends. Master limited partnerships (MLPs) and real estate investment trusts (REITs) are also top dividend payers.
Capital Dividend and Shareholders’ Equity
Capital dividends are drawn from a company’s shareholders' equity, which is equal to a firm's total assets minus its total liabilities. Shareholders' equity represents a company’s net value of a company. If all the company's assets were liquidated and all debts repaid, shareholders’ equity would be the amount that would be returned to shareholders.