Many companies offer shareholders the opportunity to purchase new shares with their dividend payments, rather than take it as cash. This scheme is called a dividend reinvestment plan.
The principal benefit is that additional shares purchased through the plan are usually (but no always) available at a small discount. One of the main advantages of dividend reinvestment plans or DRPs is that the shares are usually offered at a discount to the recent market price. This discount normally works out between two to five percent.
Another plus is that shareholders don’t have to pay brokerage when reinvesting their dividends. This is great as you can build up your stake in the company at no additional cost.
As an example, say you owned 1000 shares in a company which recently paid a final dividend of $1 per share. The shares are valued at $50 each and are offered at a five percent discount in the dividend reinvestment plan. So you could take $1000 in cash, or you could increase your holding in the stock by 21 shares (the dividend payment of $1000 divided by the discount price of $47.50). The next time the company pays a dividend, you will receive an additional 21 units of that dividend (your total dividend allotments to 521), taking advantage of compounding and indirectly forcing you to save.
The downside however is that you need to be careful with your records, so that you can quickly calculate capital gains tax when your shares are eventually sold. You should also consider whether you want to increase your stake in the company. It may be over priced, or you expect it to under-perform. In which case you may be better off taking the cash and investing it elsewhere.
It is important to consider your own situation when deciding whether or not to participate in a dividend reinvestment plan. If you are not going to notice the dividend payment, or are likely to spend the cash, then dividend reinvestment plans can be a great way to purchase discount shares, save on brokerage and force you to save. However if the cost of record keeping on all your reinvestments is going to be prohibitive, or you could invest the dividend better in another company, then perhaps you should avoid reinvesting. At the end of the day, a dividend reinvestment plan is a discount method of buying more shares.