How should a firm determine its dividend distribution policy? Discuss three diff

Question

How should a firm determine its dividend distribution policy? Discuss three different viewpoints (management, stockholders, and lenders).

Note:Investors buy shares in a company to reap a gain on their investment. The gain can be realized in a number of different ways, including through stock price appreciation, receipt of a dividend or through the firm buying back their share (at a higher price than what they bought it for). Company managers and its board of directors will determine which of these is the best method based on a number of factors. In your response try and keep these high-level thoughts in mind.

Explanation / Answer

The Rationality of Dividends

A dividend is sometimes seen as a reward to faithful stockholders. Most investors look to the stock market for a source of income. A dividend policy, regardless of its economic rationality, increases the value of a share of stock. The result is that a dividend policy can increase the demand for its shares, leading to more working capital over the long run. Therefore, even if the firm is dedicated to a policy of reinvestment and long-term growth, issuing a dividend might be rational, while at the same time satisfying their owners' need for income.

The Reinvestment Option

A firm, especially in hard times, needs all the working capital it can get. Therefore, it is in the interest of the firm as well as the owners that these profits be reinvested in the company. This means that no cash dividends are paid out. This also means that the owners of the firm see their wealth increase, while the firm has this profit to reinvest in growth.

The Interests of Stockholders

An owner of a firm's stock is a part owner of the company itself. Stockholders, as owners, like to see some return on their investment. Cash income, that is, dividends, are a clear and vivid mode of seeing a real return. Dividend income, however, is subject to income tax. Capital gains taxes are normally lower. The payment of dividends do not increase the wealth of the owner and, in fact, might decrease it, because of the larger tax liability.

The Irrelevance of Dividend Policies

A popular theory of firm dividends is that it does not matter. The

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