Several factors have been identified as incentives for company directors to approve dividend payments. Many of these are unique to the corporation and only internal managers and directors are privy to the information that grounds this decision; however, certain factors are common to publicly traded companies, but are also relevant to private companies. Although investors may be, in theory, indifferent to dividend policy, dividends themselves have proven very relevant in the eyes of investors for behavioral reasons. As most investors are risk-averse, a predictable return through dividends is often preferred to the uncertain return of capital gains resulting from reinvested earnings, despite the fact that either option would lead to the same end result in the absence of taxes and expected transaction costs.
Dividends serve as an indicator of the firm’s present and future performance and potential risk level by lending credibility to management claims, and as such may help determine the market price of the stock. Stability in dividend policy is further necessary to eliminate uncertainty and potentially poor market valuation by investors associated with unpredictable dividend payments, while a decrease in dividends often results in a negative market response as seen by a reduction in the price of the stock. Other economic rationale behind a stable dividend includes the idea that dividends limit both the amount of expensive external financing that is needed by a firm and the associated flotation costs and investor concerns which can result.
Dividends also lend more easily to “regret aversion” than capital gains in the eyes of investors as investors are more likely to prefer spending income received via dividends rather than from sale-induced capital gains (Shapiro, 542).
The imperfections of the market, including taxes and agency costs, also cause dividend policy to become highly relevant in the case of stockholder wealth. In conjunction with agency costs, the free cash flow hypothesis states that a dividend increase is a positive signal to investors as it reduces the amount of free cash flow available for unauthorized use by management. Dividends act as a disciplinary agent by restricting free cash from managers, thereby preventing empire building and unnecessary perquisites.
In theory, management should work to maximize stockholder value, and dividends often work to accomplish this goal provided that firms do not issue dividends to the point where they reject investment projects with positive Net Present Values, thereby altering their investment policy.
Shapiro, Alan C. (1990). Modern Corporate Finance. New York: Macmillan Publishing Co.