Reasons for Dividends

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REASONS FOR DIVIDENDS

Dividend policy is likely to be set in the form of a goal rather than a rigid rule, even though a definite policy has the advantage of providing the investor, or potential investor, a clear basis for choice. Investors knowing the dividend policy of the alternative companies can choose the type of company that best fits their individual investment goals. This is desirable, because stockholders differ in the extent to which they prefer dividends rather than opportunities for capital appreciation. One must remember that, while one group might well prefer capital gains, a second group of zero-tax investors may primarily be interested in dividends. This second group of investors includes universities, foundations, and private pension funds, all of which accrue no special tax advantages from capital gains as distinct from dividends. Theory says that zero-tax investors will prefer high-dividend-yield stocks, whereas the high-tax investors will prefer high-growth stocks. This implies that dividend policy will affect the types of investors who will own a company’s stock. There are several good reasons for a firm to pay dividends. These reasons include:

• The firm generates more cash internally than can be profitably reinvested.
• Dividends provide stable “income” to investors (they can plan assuming the dividends will be paid).
• The Internal Revenue Service penalizes unnecessarily retained earnings.
• Transaction costs associated with an investor selling stock make dividends less costly if the investor needs cash income.
• Changes in dividends have information for investors.
• Legal lists (eligible securities for trusts) require a record of dividend payments
• Some investors pay zero taxes, and there is no tax advantage in deferred income taxes to this group.
• If a firm is currently paying a dividend, it is difficult to stop without hurting some stockholders.
• Nonpayment of dividends may encourage “raiders”.
• A market that heavily

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