Earned equity has an economically more important impact on the dividend decision than do profitability or growth... firms pay dividends to mitigate the agency costs associated with the high cash/low debt capital structures that would eventually result if they did not pay dividends.
Why do firms pay dividends? In Dividend Policy, Agency Costs, and Earned Equity (NBER Working Paper No. 10599), authors Harry DeAngelo, Linda DeAngelo, and ReneStulz document that, for the 25 largest long-standing dividend payers in 2002, a decision to retain earnings instead of paying dividends would have resulted in firms with little or no long-term debt and enormous cash balances, far outstripping any reasonable estimate of their attractive investment opportunities. Had they not paid dividends, those firms would have had cash holdings of $1.8 trillion (51 percent of total assets), up from $160 billion (6 percent of assets), and $1.2 trillion in excess of their collective $600 billion in long-term debt. Paying dividends also prevented these firms from having significant agency problems -- the incremental costs and inherent conflicts of having managers make decisions for investors -- because the retention of earnings would have given managers command ove r an additional $1.6 trillion without access to better investment opportunities and with no additional monitoring.
Agency theory assumes that large-scale retention of earnings encourages behavior by managers that does not maximize shareholder value. Dividends, then, are a valuable financial tool for these firms because they help avoid asset/capital structures that give managers wide discretion to make value-reducing investments. The evidence presented in this paper uniformly and strongly supports this view of dividend policy.
This view also makes sense when one considers the rationale behind agency theory. Managers acquire control over corporate resources either from outside contributions of debt or equity capital, or from earnings retentions. From an agency perspective, one advantage of contributed capital is that it comes with additional monitoring, because rational suppliers of outside capital will not be forthcoming with funds at attractive prices if they believe that managers' policies merit low valuations.
Earned equity is not subject to the same ongoing, stringent discipline. Accordingly, potential agency problems are higher when a firm's capital is largely earned, since the more a firm is self-financed through retained earnings, the less it is subject to the ongoing discipline of capital markets.
Looking forward, firms with a greater demonstrated ability to self-finance most likely are also firms with a greater ability to internally fund projects that reduce stockholder wealth. Such potential waste is limited by ongoing distributions that reduce the cash resources under managerial control. A regular stream of dividends reduces the threat of agency problems that become increasingly serious as earned equity looms ever larger in the firm's capital structure.
For publicly traded industrials during 1973-2002, the proportion that paid dividends was high when the ratio of earned equity to total common equity (or to total assets) was high. It fell with declines in either ratio, coming close to zero when a firm had little or no earned equity. The authors consistently find a highly significant relationship between the decision to pay dividends and the ratio of earned equity to total equity (and to total assets), even after controlling for firm size, current and recent profitability, growth, leverage, cash balances, and dividend history.
The relationship between earned equity and the decision to pay dividends is significant economically as well as statistically, with the difference between high and low values of earned equity translating to a substantial difference in the probability of paying dividends. In fact, earned equity has an economically more important impact on the dividend decision than do profitability or growth, variables that are typically emphasized in the literature on empirical corporate payout. Overall, the results support the theory that firms pay dividends to mitigate the agency costs associated with the high cash/low debt capital structures that would eventually result if they did not pay dividends.
-- Les Picker
FAQs
Typically, companies that have consistently paid dividends are some of the most stable companies over the past several decades. As a result, a company that pays out a dividend attracts investors and creates demand for their stock. Dividends are also attractive for investors looking to generate income.
Why do firms pay dividends? ›
Paying dividends allows companies to share their profits with shareholders, which helps to thank shareholders for their ongoing support via higher returns and to incentivise them to continue holding the stocks.
Which is the most common reason why firms pay dividends? ›
firms pay dividends to mitigate the agency costs associated with the high cash/low debt capital structures that would eventually result if they did not pay dividends.
Why is it good for a company to pay dividends? ›
Dividends are a portion of a company's profits that are paid to investors (i.e. shareholders) on a regular basis. This may provide a source of income. Dividend income can help offset declines in share prices. The growth potential of dividend income can help minimize the impact of inflation.
What makes a company decide to pay dividends? ›
A company's board of directors is responsible for its dividend policy and determining the size of a dividend payment. Depending on a company's growth goals, earnings and cash flows, its industry, and other factors, the board will determine an appropriate (if any) dividend payment.
What are the advantages of paying dividends? ›
Five of the primary reasons why dividends matter for investors include the fact they substantially increase stock investing profits, provide an extra metric for fundamental analysis, reduce overall portfolio risk, offer tax advantages, and help to preserve the purchasing power of capital.
Why do firms pay special dividends? ›
Why Do Companies Pay Special Dividends? Companies may elect to pay out a special dividend to distribute windfall profits, from a restructuring, or to reward shareholders. By declaring a special dividend, a company can also signal to the market that its financials are sound and has good growth prospects.
Why do firms increase dividends? ›
Dividends represent company profits that are paid to shareholders. When a dividend increase is the result of improved cash flows, it is often a positive indicator of company performance. Another reason for a dividend hike is a shift in company strategy away from investing in growth and expansion.
Why are dividends more important than ever? ›
Dividends can provide not only income, but they may also accelerate the payback on investment.
What are dividends paid by the firm? ›
Dividends are distributions of property a corporation may pay you if you own stock in that corporation. Corporations pay most dividends in cash. However, they may also pay them as stock of another corporation or as any other property.
The Pros & Cons Of Dividend Stock Investing
- Pro #1: Insulation From The Stock Market. ...
- Pro #2: Varied Fluctuation. ...
- Pro #3: Dividends Can Provide A Reliable Income Stream. ...
- Con #1: Less Potential For Massive Gains. ...
- Con #2: Disconnect Between Dividends & Business Growth. ...
- Con #3: High Yield Dividend Traps. ...
- Further Reading.
20 high-dividend stocks
| Company | Dividend Yield |
|---|
| Angel Oak Mortgage REIT Inc (AOMR) | 10.71% |
| International Seaways Inc (INSW) | 10.66% |
| CVR Energy Inc (CVI) | 9.35% |
| Civitas Resources Inc (CIVI) | 9.33% |
17 more rows4 days ago
“Clause 127 — This clause corresponds to section 207 of the Companies Act, 1956 and seeks to provide that where the dividend has been declared but has not been paid or the warrants have not been posted within thirty days of declaration, every director who is knowingly party to the default shall be punishable with ...
Why do companies choose to offer a dividend? ›
A greater demand for a company's stock will increase its price. Paying dividends sends a clear, powerful message about a company's future prospects and performance, and its willingness and ability to pay steady dividends over time provides a solid demonstration of financial strength.
Why would a corporation choose to pay a dividend? ›
Many investors like the steady income associated with dividends, so they will be more likely to buy that company's stock. Investors also see a dividend payment as a sign of a company's strength and a sign that management has positive expectations for future earnings, which again makes the stock more attractive.
What is the purpose dividend? ›
The Purpose Dividend explores how purpose-driven businesses can drive the UK's economic recovery. To solve the economic challenges of our time we need a revolution in business practice.
Why do firms issue stock dividends? ›
Dividends, whether in cash or in stock, are the shareholders' cut of the company's profit. They also are a reward for holding the stock rather than selling it. A company may issue a stock dividend rather than cash if it doesn't want to deplete its cash reserves.
Why do companies raise dividends? ›
Dividends represent company profits that are paid to shareholders. When a dividend increase is the result of improved cash flows, it is often a positive indicator of company performance. Another reason for a dividend hike is a shift in company strategy away from investing in growth and expansion.
Why do some companies pay dividends and others don't? ›
Companies that offer dividends provide investors with a regular income as the stock price moves up and down in the market. Companies that don't offer dividends are typically reinvesting revenues into the growth of the company itself, which can eventually lead to greater increases in share price and value for investors.
