With no taxes or market imperfections and assuming constant investment strategy, the dividends paid by a company are largely irrelevant in determining the value of the company.
Hence, dividend policy cannot improve the wealth of shareholders. This statement should come as a surprise. We already learned that the prices of stocks and bonds are the present values of their streams of future cash flows. For stocks, these streams are represented by their dividends. Now we say that it does not matter what dividends companies pay. In fact, companies could pay no dividends at all.
Indeed the stock price is the present value of its future dividends. No company can simply refuse to ever pay dividends. If a company took its shareholders money and refused to ever return it, the stock price would be zero. Companies that do not pay dividends are really just companies that are not currently paying dividends.
Most finance textbooks say that in a perfect market it does not matter whether companies pay dividends now or reinvest those dividends. Reinvested dividends increase expected future dividends later. This is the essence of the dividend irrelevance result. Investors who want dividends and are not getting them can just sell some of their shares to generate the cash. Those who are getting dividends and do not want them can simply reinvest their dividends into new shares. Indeed, reinvestment of dividends is extremely common.
The result that dividend policy is irrelevant is technically true only if companies are able to reinvest their dividends in projects that earn at least zero NPV. That is, we must hold the company’s asset investment policy constant by assuming that the company can invest in projects that have zero NPV. If companies cannot reinvest dividends into projects that earn at least zero NPV, then they should indeed pay more dividends. They should pay out all of their money in dividends. By contrast, companies that can reinvest dividends into projects with positive NPVs should pay lower dividends. In fact, they should pay no dividends at all. If, however, the use of debt is indeed irrelevant, they can pay dividends by borrowing the money to generate enough cash to pay dividends and have enough to fund their capital investments.
But why would they want to do so? Only if dividends do matter. The reality is that dividends can matter. Dividends are thought to serve as a signal to investors that the company is doing well. When companies cut dividends, investors usually react by lowering the price of the stock. The dividend reduction is seen as a signal that bad times lie ahead. Companies typically pay fairly constant dividends and raise dividends only when they know they can sustain the dividends at the higher level. They cut dividends only as a last resort.
Companies that have a lot of cash and not a lot of positive NPV opportunities but who do not want to pay out dividends often return cash to their shareholders by repurchasing shares. Share repurchase does not increase shareholder wealth, but it can be a good use of cash that would otherwise sit idle or be squandered by management.
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Last updated: January 9, 2011