How and why companies pay dividends

How and why companies pay dividends gy pmunrra I Acza6pR 03, 2010 | 4 pagos 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 steady flows 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 the purpose 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 etermine how much to pay, let’s look at different arguments for and against dividends policies. First, some financial analysts feel that the consideration of a dividend policy is irrelevant because investors have the abilit to create homemade dividends. ThlS is done by adjus ora investor’s own prefer a steady stream of in me a (whose interest pay paying stock (whose elv to reflect the stors looking for invest in bonds er than a dividend ause their interest payments won’t change, those who own bonds don’t care about a particular company’s dividend policy.

The second argument suggests that little to no

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dividend payout is more favorable for investors. Supporters of this policy pont out that taxation on a dividend is higher than on capital 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 i Swipe to vlew next page increase the value of the firm as a whole and consequently increase 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 followlng: ndertaking more projects, 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 payout is more important for investors because dividends provide certainty about the company’s financial well being,• dividends are alsa attractive for investors looking to secure current income.

The principle behind the attractiveness of a company’s ability to pay high dividends is that it provides certainty about the company’s financial well being. There are many examples of how the decrease and increase of a dividend distribution can affect the Price of a security. Companies that have a long standing history of stable dividend payouts would be negatively affected by Iowering or omitting dividend distributions; these companies would be positively affected by increasing dividend payouts or making additional payouts of the same dividends.

Furthermore, companies without a dividend history are generally viewed favorably when they declare new dividends. Now, should the company decide to follow either the high or Iow ividend method, it would use one of three main approaches: residual, stability, or a compromise between the two. Residual Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects.

As a resu dividend policy choose to rely on internally generated equity to finance any new projects. As a result, dividend payments can only come out of the residual or leftover equity after all project capital requirements are met. These company’s usually attempt to maintain balance in their debt/equity ratios before aking any dividend distributions, which demonstrates that such a company decides upon dividends only if there is enough money leftover after all operating and expansion expenses are met.

For example, let’s suppose that a company named CBC has recently earned $1 ,000 and has a strict policy to maintain a debt/ equity ratio of 0. 5 (one part debt to every two parts of equity). Now, say this company had a project with a capital requirement of $gOO. In order to maintain the debt/equity rat10 ofO. 5, CBC would have to pay 1/3 by using debt ($300) and 2/3 ($600) by using equity. In other words the company would have to borrow $300 and use $600 of its equity to maintain the 0. ratio, leaving a residual amount of $400 (SI ,000-$600) for dividends. On the other hand, if the project had a capital requirement of $1 ,500, the debt requirement would be $500 and the equity requirement would be $1 ,000, leaving $O ($1 ,000-$1 ,000) for dividends. Should any project require an equity portion that is greater than the company’s available levels, the company would issue new stock. Stability The fluctuation of dividends created by the residual policy ignificantly contrasts the certaino,’ of the dividend stability policy.

With the stability policy, companies may choose a cyclical policy that sets dividends at a fixed fraction of qu 3Lvf4 policy, companies may choose a cyclical policy that sets dividends at a fixed fraction of quarterly earnings, or they may choose a stable policy whereby quarterly dividends are set at a fraction of yearly earnings. In either case, the aim of the dividend stability policy is to reduce uncertainty for investors and to provide them with income. Suppose Our imaginary company CBC arned the SI ,000 for the year (with quarterly earnings of $300, 3200, $ 100, $400).

If CRC decided upon a stable policy of 10% of yearly earnjngs ($1 it would pay $25 ($100/4) to shareholders every quarter. Alternatively, if CBC decided upan a cyclical policy, the dividend payments would adjust every quarter to be $30, $20, $10, and $40 respectively. In either instance, company’s following this policy are always attempting to share earnings with shareholders rather than searching for projects to invest excess cash. Hybrid The final approach is a combination etween the residual and stable dividend policy.

Using this approach, companies tend to View the debt/equity ratio as a long-term rather than a short-term goal. n today’s markets, this approach is commonly used by companies that pay dividends. As these companies Will generally experience business cycle fluctuations, they Will generally have one set dividend, which is set as a relatively Small portion of yearly income and can be easily maintained. On top of this set dividend, these companies Will Offer another extra dividend paid only when income exceeds general obtained levels.