How and why companies pay dividends

How and Why Do Companies Pay Dividends?

Look anywhere on the web and you're bound to find information on how dividends affect stockholders: the information ranges from a consideration of steadyflows of income, to the proverbial "widows and orphans," and to the many different tax benefits that dividend-paying companies provide. An important part missing in many of these discussions is thepurpose of dividends and why they are used by some companies and not by others. Before we begin describing the various policies that companies use to determine how much to pay, let's look at differentarguments for and against dividends policies. First, some financial analysts feel that the consideration of a dividend policy is irrelevant because investors have the ability to create homemadedividends. This is done by adjusting a personal portfolio to reflect the investor's own preferences. For example, investors looking for a steady stream of income are more likely to invest in bonds (whoseinterest payments don't change), rather than a dividend paying stock (whose value can fluctuate). Because their interest payments won't change, those who own bonds don't care about a particular company'sdividend policy.

The second argument suggests that little to no dividend payout is more favorable for investors. Supporters of this policy point out that taxation on a dividend is higher than oncapital gain. The argument against dividends is based on the belief that a firm who reinvests funds (rather than pays it out as a dividend) will increase the value of the firm as a whole and consequentlyincrease the market value of the stock. According to the proponents of the no-dividend policy, a company's alternatives to paying out excess cash as dividends are the following: undertaking moreprojects, repurchasing the company's own shares, acquiring new companies and profitable assets, and reinvesting in financial assets. In opposition to these two arguments is the idea that a high dividend...