Dividend Policy

At the end of each year, every publicly traded company has to decide whether to return cash to its stockholders and, if yes, how much in the form of dividends. The owner of a private company has to make a similar decision about how much cash he plans to withdraw from the business, and how much to reinvest. This is the dividend decision, and we begin this chapter by providing some background on three aspects of dividend policy. One is a purely procedural question about how dividends are set and paid out to stockholders. The second is an examination of widely used measures of how much a firm pays in the dividends. The third is an empirical examination of some patterns that firms follow in dividend policy.

Having laid this groundwork, we look at three schools of thought on dividend policy. The dividend irrelevance school believes that dividends do not really matter, because they do not affect firm value. This argument is based upon two assumptions. The first is that there is no tax disadvantage to an investor to receiving dividends, and the second is that firms can raise funds in capital markets for new investments without bearing significant issuance costs. The proponents of the second school feel that dividends are bad for the average stockholder because of the tax disadvantage they create, which results in lower value. Finally, there are those in a third group who argue that dividends are clearly good because stockholders (or at least some of them) like them.

Although dividends have traditionally been considered the primary approach for publicly traded firms to return cash or assets to their stockholders, they comprise only one of many ways available to the firm to accomplish this objective. In particular, firms can return cash to stockholders through equity repurchases, where the cash is used to buy back outstanding stock in the firm and reduce the number of shares outstanding. In addition, firms can return some of their assets to their stockholders in the form of spin offs and split offs. This chapter will focus on dividends specifically, but the next chapter will examine the other alternatives available to firms, and how to choose between dividends and these alternatives.

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