The dividend policy of a firm is irrelevant in a perfect capital market because the shareholder can effectively undo the firm's dividend strategy. If a shareholder receives a greater dividend than desired, he or she can reinvest the excess. Conversely, if the shareholder receives a smaller dividend than desired, he or she can sell off extra shares of stock. This argument is due to MM and is similar to their homemade leverage concept, discussed in a previous chapter.
Stockholders will be indifferent between dividends and share repurchases in a perfect capital market.
Because dividends in the United States are taxed, companies should not issue stock to pay out a dividend.
Also because of taxes, firms have an incentive to reduce dividends. For example, they might consider increasing capital expenditures, acquiring other companies, or purchasing financial assets. However, due to financial considerations and legal constraints, rational firms with large cash flows will likely exhaust these activities with plenty of cash left over for dividends.
In a world with personal taxes, a strong case can be made for repurchasing shares instead of paying dividends.
Nevertheless, there are a number of justifications for dividends even in a world with personal taxes:
Investors in no-dividend stocks incur transaction costs when selling off shares for current consumption.
Behavioral finance argues that investors with limited self-control can meet current consumption needs via high-dividend stocks while adhering to a policy of "never dipping into principal."
Managers, acting on behalf of stockholders, can pay dividends to keep cash from bondholders. The board of directors, also acting on behalf of stockholders, can use dividends to reduce the cash available to spendthrift managers.
The stock market reacts positively to increases in dividends (or an initial payment) and negatively to decreases in dividends. This suggests that there is information content in dividend payments.
High (low) dividend firms should arise to meet the demands of dividend-preferring (capital gains–preferring) investors. Because of these clienteles, it is not clear that a firm can create value by changing its dividend policy.
