A company can offer a dividend to convince an investor to buy its stock instead of the shares of a competitor, because the investor enjoys receiving a stream of income that does not force him to sell his shares. An investor may also decide against investing in a company if it pays out large dividends, because the investor wants the company to make profitable investments instead of giving his money back.
Stockholders' preferences influence dividend policies. An investor who has few additional sources of income, such as a retiree, is more likely to choose stocks that have significant dividend payouts. She is likely to be in a lower tax bracket, and the dividends are a significant source of income. She also prefers to collect cash now, instead of waiting for a future payout. An executive who earns $500,000 a year might not want a dividend, because she has to pay heavy taxes on any dividend she receives, and the dividend is not a major portion of her income.
A company that earns a steady income is more likely to pay out high dividends. When the managers can easily predict the level of profit that the company will earn in future years, the company can pay out more money without risking a future cash shortage.
Managers' power over the company affects the company's dividend policies. If managers receive large bonuses for good performance or hold a high percentage of the company's shares, they typically prefer to reinvest the company's profits. If managers hold fewer shares and have fewer performance incentives, outside stockholders may ask for higher dividends as a safeguard because managers have less motivation to achieve high profits with the assets they manage.
Under the residual-dividend model, the company pays a dividend because it has no better use for its profits. The company subtracts the cash that it can invest in worthwhile activities from its total profits and returns the remaining cash to its investors. The company decides which activities are worthwhile by establishing a threshold rate, such as stating that it will only invest in a project that offers a 7 percent return on its investment.
Economic conditions affect dividend policies. When the economy is performing badly, investors prefer greater dividends. If economic conditions are good and the stock market is rising, investors feel more confident about leaving their cash in the company, because the company has better prospects for growth and future income.
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