Shareholders invest in companies for two basic reasons: 1) long-term capital gain, and 2) a current...

Shareholders invest in companies for two basic reasons: 1) long-term capital gain, and 2) a current revenue stream via dividends. Companies use various methods to satisfy one or both of these shareholder objectives. Identify each principle distribution method, and discuss the pros and cons to both shareholder and company.

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Expert Solution

The company can use the profits or cash flows it generates in two ways. Either it can give a part or whole of it to the shareholders in the form of dividends, or it can retain it and use it for expansion.

If the company decides to give back through dividends, then, while investors can keep receiving income in the form of dividends, the company would be denying itself the opportunity to use those same funds to expand and grow further.

The con for the shareholder is that, if the company pays her or him dividends now, the company may be denying shareholders long-term capital gain. This is because, if the company had decided to use those funds to invest in itself, it would have created shareholder value in the long-term.

Now, if the company decides to retain all the profits and invest in itself, the con for the shareholder is that there will be no income for the holding period of the stock. However, share holders might get a much better long-term capital gain as the company could grow much faster thanks to the investment.

The advantage for the company to do so is that it can keep growing if it retains and invests its profits. The probable con is that it might be making investors unhappy in the short-term. As long as the company can covert retained earnings into growth, it would be able to keep shareholders at bay.

The one disadvantage of doing this for both the shareholders and the company is that, if the company is huge and is in the mature stage, and the industry it operates in is also in the mature stage, then there would be no value in retaining earnings because the scope for growth is reduced. The company is then, better off declaring dividends.

jeff jeffy answered 11 months ago

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