When managers decide on the dividend, their primary concern seems to be to give shareholders a "fair" payment on their investment. However, most managers are very reluctant to reduce dividends and will not increase the payout unless they are confident it can be maintained.

As an alternative to dividend payments, the company can repurchase its own stock. In recent years companies have bought back their stock in large quantities, but repurchases do not generally substitute for dividends. Instead they are used to return unwanted cash to shareholders or to retire equity and replace it with debt.

If we hold the company's investment decision and capital structure constant, then payout policy is a trade-off between cash dividends and the issue or repurchase of common stock. Should firms retain whatever earnings are necessary to finance growth and pay out any residual as cash dividends? Or should they increase dividends and then (sooner or later) issue stock to make up the shortfall of equity capital? Or should they reduce dividends and use the released cash to repurchase stock?

If we lived in an ideally simple and perfect world, there would be no problem, for the choice would have no effect on market value. The controversy centers on the effects of dividend policy in our flawed world. Many investors believe that a high dividend payout enhances share price. Perhaps they welcome the self-discipline that comes from spending only dividend income rather than having to decide whether they should dip into capital. We suspect also that investors often pressure companies to increase dividends when they do not trust management to spend free cash flow wisely. In this case a dividend increase may lead to a rise in the stock price not because investors like dividends as such but because they want managers to run a tighter ship.

The most obvious and serious market imperfection has been the different tax treatment of dividends and capital gains. In the past, dividends in the United States have often been much more heavily taxed than capital gains. In 2003 the maximum tax rate was set at 15% on both dividends and gains, though capital gains continued to enjoy one advantage—the tax payment is not due until any gain was realized. If dividends are more heavily taxed, highly taxed investors should hold mostly low-payout stocks, and we would expect high-payout stocks to offer investors the compensation of greater pretax returns.

This view has a respectable theoretical basis. It is supported by some evidence that, when dividends were at a significant tax disadvantage in the U.S., gross returns did reflect the tax differential. The weak link is the theory's silence on the question of why companies continued to distribute such large dividends when they landed investors with such large tax bills.

The third view of dividend policy starts with the notion that the actions of companies do reflect investors' preferences; thus the fact that companies pay substantial dividends is the best evidence that investors want them. If the supply of dividends exactly meets the demand, no single company could improve its market value by changing its payout policy.

It is difficult to be dogmatic over these controversies. If investment policy and borrowing are held constant, then the arguments over payout policy are largely about shuffling money from one pocket to another. Unless there are substantial tax consequences to these shuffles, it is unlikely that firm value is greatly affected either by the total amount of the payout or the choice between dividends and repurchase. Investors' concern with payout decisions seems to stem mainly from the information that they read into managers' actions.

The bottom-line conclusion, if there is one, is that payout varies over the life cycle of the firm. Young growth firms pay no cash dividends and rarely repurchase stock. These firms have profitable investment opportunities. They finance these investments as much as possible from internally generated cash flow. As firms mature, profitable investment opportunities shrink relative to cash flow. The firm comes under pressure from investors, because investors worry that managers will overinvest if there is too much idle cash available. The threat of a lagging stock price pushes managers to distribute cash by repurchases or cash dividends. Committing to a regular cash dividend sends the more credible signal of financial discipline.