Question

1. One argument for high dividend payout is the desire of investors for current income. Explain why this argument does/does not work in a perfect capital market with no transaction costs. Explain how this argument does/does not work in real life.

Answer 1

Answer: There are two types of investors. One who wants growth and higher returns by investing into growth stocks and other who wants dividend as a regular income so they invest into dividend yield stocks.

Stock market has risk and uncertainty. Companies that are listed on exchange, will not always be in profit, their profit may come down in a particular accounting period. Dividend is a part of company's profit, whenever companies get profit, they distribute it to its shareholders in the form of dividend but if companies do not earn profit or earn lower profit, they won't be able to pay the dividends in that particular year. They may also retain profit for growth and expansion purpose in any year or so then they won't pay any dividend. Investors who seek only dividend as regular income, will not get dividend in those years.

So investors should be flexible enough, they may get dividend and capital appreciation both but only when they invest for longer term. Equity market has its cycle, investors need to wait for companies to perform better in capital markets.