Question

Payout policies of the firm should be aligned with the shareholders’ wealth maximization objective. In general, name at least three reasons why some companies should be paying their earnings out in dividends; alternatively, name at least three reasons when it might be optimal for companies to reduce dividends and retain more of the earnings.

Answer 1

Reasons why some companies should be paying their earnings out in dividends

The primary goal of a company's dividend policy is to benefit shareholders. Therefore a company should follow such a policy where shareholders are made better of by the policy. Few reasons are as follows

1. Investors may use dividends to cover living expenses, which are usually rather stable from period to period. If there is a radical decline in the dividend income then the investors may be forced to sell the shares to obtain funds for living expenses. However if a company pays more dividends then it will produce excess cash that the investors would reinvest. Therefore Investors will be benefitted when a company pays more dividends.

2. If a company pays less dividend then its share prices might be low. This would make the firm an easy takeover target. Therefore the company should pay more dividends.

3. When a company has a sound liquidity position and it can collect funds from various sources of finance then company should pay more dividends to its shareholders as it not face any financial difficulty and at the same time it will keep the shareholder motivated to invest more in the company.

Reasons when it might be optimal for companies to reduce dividends and retain more of the earnings

1. A Company might have surplus funds and it does not want to pay temporary high dividends to its shareholders. It might utilize such funds for acquisition which can create additional value for the company.

2. If a company has large number of positive net present value projects then it might want to invest their funds in such projects rather than paying high dividends to shareholders.

3. If flotation costs are high, external equity issue is very costly so a company might follow a tight dividend policy. It would be better for the company to retain its earnings in this situation.