When a company has a surplus of profit, it can be used either pay back the shareholders or reinvest into the business. The way that company pay back to shareholders is call dividend payout. In the recent years, the number of companies paying dividends has declined. For example, the PSEG Company in the United State, the payout ratio was about 67% in 2004 and fallen to 45% by 2007.Shows in the graph below: (http://www.pseg.com/index.jsp) This essay will mainly discuss the advantage and disadvantage about the dividend-paying. What are dividends? Dividends are payment made by corporation to the shareholders. Dividends come from the profit earned by company. There are two ways where company spends the surplus of profit, one is to reinvest to the business and the other is to pay back to the shareholders as dividends. The companies who pay dividends are usually taking no benefit if the reinvest the surplus profit back into the business, under this condition dividends are chosen to pay to the shareholders, which is call payout. The forms of dividends are variable. The most common one will be the made by cash, which is the most common method of sharing corporate profits with the shareholders of the company. The second one is the stock dividends that is paid in form of additional share and it is counted by proportion, for example, if the shareholder owns 100 shares of the stock with 5% stock dividends, the shareholder can gain 5 more shares. Others like property dividends are taken as dividends payout as well.
Advantage of dividend payout policy
There is certain amount of people of the rightist position state that company pays a high dividend payout is important for investors for the reasons that paying dividends can convince the shareholders about the company's financial well-being. The higher rate of dividends payout shows better the company operating as well as larger number of profit, which might attracts the investors.
Dividends are also attractive for the investors who want to get the stable current income easily. â€œThere is also a natural clientele of investors, such as the elderly, who looking to their stock portfolios for a steady source of cash to live onâ€Â (P456, Richard, 2008). In principle, the shareholders could sell a part of the shares to gain money even if the company does not pay dividends, but it is more convenience for the investors to get the money if companies pay the dividends by checks. In this case, the payout policy of cash dividends will reduce the cost of transaction as well as the inconvenience for the shareholders selling the shares.
In addition, the long-term stable dividends payouts could help the company less affected by the changes of the dividends. Those companies with long history of stable dividends will be less influenced if the dividends decrease, but will be positively affected when dividends payout increases or even dividends stay the same level. Furthermore, companies without a dividend history are generally viewed favorably when they declare new dividends. The dividends announcement has resulted in a 4% rise of the stock price according to the dividend initiations studied by Healy and Palepu (P448, Richard, 2008).
Many companies have taken the dividends paid back to shareholders as payout policy. For example Microsoft, the largest software company in the entire world, has announced their first dividends payout in 2003. The amount of the money has been divided into two forms of dividends, one was one-time dividends and the other was stock dividends paid quarterly installments by a unit as per share. (P457, Richard, 2008).
Disadvantage of dividend payout policy
Firstly, the radical state that dividends payout can be heavier than capitals gain when taxation of dividends is larger than the capital gains. Under this condition, company should put the spare profit back into the business by repurchase shares. It makes sense for the reasons that the capital gains have a tax advantage. When companies use the money to repurchase the share, the income will be larger because with the lower rate of tax on capital earnings, comparing to dividends payouts to shareholders with higher rate of tax on dividends. In the banking industries, a part of banks have stopped paying dividends to shareholders in 2009, according to the Capital Report. In the meanwhile, there are 202 firms have cut their dividends and 74 of which paid none at all (Web1).
Secondly, the level of dividends payout can reflect the information about the confidence of the management from the company in the future, which will have an influence to the stock price. Generally, companies that pay dividends are sending a message to the market that their earnings are real which will result in the investors comfort about their investment. On the other hand, once the companies decide to cut the dividend it is also sending the information that they cannot maintain the dividends. However, the company might be able to cheat on their operation by overstating the earning to attract investors, but it is risky in the long term because the actual condition of the company will not have sufficient money to pay the dividends. The consequence will be costly if the companies choose a high dividend without getting enough profit. Most managers will not change the dividends without consideration about the operation of company, but they will increase the dividends only if they are confident it can be maintained.
Thirdly, the consideration of a dividend policy might be irrelevant because investors have the ability to create their own dividends. It means that investors can be able to make their own â€˜dividendâ€™ by adjust the investment into different areas. For example, the investors who prefer a stable income are more likely to put their money into the bonds with the stable interest rates. In the case, the stock with dividends pay back will lose the advantage because of the flexible value. Investors who have invested to the bonds will not pay attention to the dividend policy of a particular company.
Taking the dividend payout policy can attract certain amount of investors, and it is convenience for those investors who require stable and simple income. But dividends sometimes have tax disadvantage if the tax rate of dividend is higher than capital gains. And dividends are usually more flexible, comparing to the interest rates of bonds. It is important for a company to think whether to take the dividend payout policy by considering the assets, earnings, investments opportunities, market value and other factors about the company.