1. Why do firms pay dividends? What, in general, are the advantages and disadvantages of paying cash dividends?
Taking into account the many theories of dividend policy including the Dividend Irrelevance Theorem, the Information Effect, The Clientele Effect and Corporate Control Issues, firms should pay out as dividends “any cash flow that is surplus after the firm has invested in all available positive net present value projects.” In some cases, this may be a way of showing that the company is financially stable and capable of fulfilling dividend obligations. It may also be a way for companies to mitigate agency problems when they have excess cash.
Advantages of paying cash dividends include:
• A signal of the value and stability of the business
• A means of distributing excess cash
• The tendency to increase stock prices when announced
• A way of keeping managers in check and mitigating agency problems when high retained earnings don’t max out shareholders’ value
• Higher proportion of pension funds/ tax exempt institutions are the shareholders
Disadvantages of paying cash dividends include:
• Taxation at a higher rate than capital gains
• Limits on the growth the company if dividends are paid instead of completing a positive NPV project.
• Once established they are difficult to eliminate and doing so will often affect the price of the stock
• They have no impact on the value of a company and the stockholders can “create” dividends by simply selling the stock
1. Why do firms pay dividends? What, in general, are the advantages and disadvantages of paying cash dividends?
Taking into account the many theories of dividend policy including the Dividend Irrelevance Theorem, the Information Effect, The Clientele Effect and Corporate Control Issues, firms should pay out as dividends “any cash flow that is surplus after the firm has invested in all available positive net present value projects.” In some cases, this may be a way of showing that the company is financially stable and capable of fulfilling dividend obligations. It may also be a way for companies to mitigate agency problems when they have excess cash.
Advantages of paying cash dividends include:
• A signal of the value and stability of the business
• A means of distributing excess cash
• The tendency to increase stock prices when announced
• A way of keeping managers in check and mitigating agency problems when high retained earnings don’t max out shareholders’ value
• Higher proportion of pension funds/ tax exempt institutions are the shareholders
Disadvantages of paying cash dividends include:
• Taxation at a higher rate than capital gains
• Limits on the growth the company if dividends are paid instead of completing a positive NPV project.
• Once established they are difficult to eliminate and doing so will often affect the price of the stock
• They have no impact on the value of a company and the stockholders can “create” dividends by simply selling the stock
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