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Imagine a mature company, which has stable earnings and made a profit this year. The company is planing to pay out a part of this earnings to its shareholders. Assuming the stock price goes down exactly what is paid out per share the shareholders wealth doesn't change.

Now a few weeks later the company decides to start a new project, for which it needs to borrow money (because it paid out its excess returns) and therefore pay some interest for this borrowed money. Even when it would not do any investments it could lend the excess money to someone else and earn a little interest on that.

When the company doesn't pay a dividend the money stays within the company and therefore the company is worth more, which will be reflected in the share price (assuming efficient markets). So when the shareholders need money they could sell some of their (higher priced) stocks.

As we see from the example above the company can either choose to pay out the money and earn nothing, or keep the money and use it for investments or earn some interest on it. The company has an (opportunity) cost by paying out dividends, and is therefore not the optimal choice to do so.

Also if we assume that the increase in the share price is generally taxed as a capital gain, and capital gains are often taxed at a lower rate than income in the case of dividends.

So my question is: Why does it make sense, from a economically rational point of view, assuming both the company and also the investors want to maximize the shareholders value, to pay out a dividend?

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But markets are not efficient! Also, only long term capital gains are taxed less (asset held longer than 12 months). And most good compaies do invest part of their earnings, not all of it goes to dividends. – Victor Feb 7 at 20:18
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@Victor thats why I said assuming efficient markets – lukstei Feb 7 at 20:57
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But if markets are not efficient there is no reason to assume they are. Then you are not talking about reality. – Victor Feb 7 at 22:39
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You proceed from an invalid assumption. Markets are not efficient, and investors are irrational. If this question is purely theoretical then it is off topic and should be closed. Here is actual data regarding the relationship between the price of a stock and the dividend it pays. If anything, the price of the stock went down because the manager lowered the dividend. But look at the history and you will see that it is a myth that the price of the stock goes down by the value of the dividend paid. stockcharts.com/h-sc/… – Jack Swayze Sr Feb 8 at 3:37
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Because there are basically two reasons to buy stock in a company: either you expect the stock price to go up, or you expect it to pay dividends. Since many people & institutions buy primarily for the second reason, their purchases increase demand, and so the stock price. – jamesqf Feb 8 at 5:36
up vote 46 down vote accepted

The main reason, as far as I can see, is that the dividends are payments with which the shareholders may do what they want.

Capital that the company has no use for does not make a significant positive return on investment, as you pointed out, yes the company could accrue interest, but that is not going to make the company large sums of cash.

While the company may be great at making shoes - maybe even the best in the world - doesn't mean they are good investors. Sure they could dabble at using their capital to invest in other equities, but they don't, because they just want to focus on making shoes.

If the dividend goes to the investors, they can do what they wish, be it reinvest in the company, or invest elsewhere. Other companies that may make good use of the capital, and create significant returns on it are one such example.

That is the rational answer, beyond that, one of the main reasons is that people like the feeling of receiving dividends - it might not be the answer you are looking for, but many people prefer companies that pay dividends for no rational reason over companies which grow their asset value.

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that makes perfect sense, thank you! – lukstei Feb 7 at 21:33
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Actually the discipline required to pay regular dividends ensures that the company is better run - you cant use accounting tricks you pay out real $$ - see enron for an example – Pepone Feb 7 at 22:17
    
But in the real world, companies buy shares from other public companies too frequently. And for that reason when a big company fails, there may be collapse on stock exchange because many other companies hold shares and their stock price is significantly affected by the "bad investment". – i486 Feb 8 at 8:41
    
@i486 not sure you point is - having to buy the dog company's is an argument against index based funds. – Pepone Feb 8 at 21:44
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@Pepone There is a trick called "Pyramid scheme" or "Ponzi scheme" that allows real $$ payout, and then scam you over even harder. Some of them flew quite high. – Dorus Feb 9 at 14:09

First, you need to understand that not every investor's goals are the same. Some investors are investing for income. They want to invest in a profitable company and use the profit from the company as income. If that investor invests only in stocks that do not pay a dividend, the only way he can realize income is to sell his investment. But he can invest in companies that pay a regular dividend and use that income while keeping his investment intact.

Imagine this: Let's say I own a profitable company, and I offer to sell you part ownership in that company. However, I tell you this upfront: no matter how much profit our company makes, you will never get a penny from me. You will be getting a stock certificate - a piece of paper - and that's it. You can watch the company grow, and you can tell yourself you own it, but the only way you will personally benefit from your investment would be to sell your piece to someone else, who would also never see a penny in profit. Does that sound like a good investment?

The fact of the matter is, stocks in companies that do not distribute dividends do have value, but this value is largely based on the potential of profits/dividends at some point in the future. If a company vows never ever to pay dividends, why would anyone invest? An investment would be more of a donation (like Kickstarter) at that point.

A company that pays dividends is possibly past their growth stage. That doesn't necessarily mean that they have stopped growing altogether, but remember that an expansion project for any company does not automatically yield a good result. If a company does not have a good opportunity currently for a growth project, I as an investor would rather get a dividend than have the company blow all the profit on a ill-fated gamble.

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thanks for the answer, sorry can't upvote with my rep – lukstei Feb 7 at 21:33
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No idea what prompted the DV, but a +1 from me. Actually, question is borderline OT, in my opinion. – JoeTaxpayer Feb 7 at 21:40
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Stocks would be valuable to another company that wants to acquire that company. – immibis Feb 8 at 7:45
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This leaves out the potential voting power given from shares. This is not useful practically to all but the richest individuals but does have a value to someone. – Vality Feb 8 at 11:41
    
So why does anyone buy Berkshire Hathaway?? It hasn't paid a dividend in over 50 years, and never will. Is it just the stock buyback, or is that Wall Street turning perceived value into real value? – krs013 Feb 8 at 19:22

Actually, share holder value is is better maximised by borrowing, and paying dividends is fairly irrelevant but a natural phase on a mature and stable company.

Company finance is generally a balance between borrowing, and money raised from shares. It should be self evident with a little thought that if not now, then in the future, a company should be able to create earnings in excess of the cost of borrowing, or it's not a very valuable company to invest in! In fact what's the point of borrowing if the cost of the interest is greater than whatever wealth is being generated? The important thing about this is that money raised from shares is more expensive than borrowing.

If a company doesn't pay dividends, and its share price goes up because of the increasing value of the business, and in your example the company is not borrowing more because of this, then the proportion of the value of the company that is based on the borrowing goes down. So, this means a higher and higher proportion of the finance of a company is provided by the more expensive share holders than the less expensive borrowing, and thus the company is actually providing LESS value to share holders than it might.

Of course, if a company doesn't pay a dividend AND borrows more, this is not true, but that's not the scenario in your question, and generally mature companies with mature earnings may as well pay dividends as they aren't on a massive expansion drive in the same way.

Now, this relative expense of share holders and borrowing is MORE true for a mature company with stable earnings, as they are less of a risk and can borrow at more favourable rates, AND such a company is LIKELY to be expanding less rapidly than a small new innovative company, so for both these reasons returning money to share holders and borrowing (or maintaining existing lending facilities) maintains a relatively more efficient financing ratio.

Of course all this means that in theory, a company should be more efficient if it has no share holders at all and borrows ALL of the money it needs. Yes. In practise though, lenders aren't so keen on that scenario, they would rather have shareholders sharing the risk, and lending a less than 100% proportion of the total of a companies finance means they are much more likely to get their money back if things go horribly wrong.

To take a small start up company by comparison, lenders will be leary of lending at all, and will certainly impose high rates if they do, or ask for guarantors, or demand security (and security is only available if there is other investment besides the loan). So this is why a small start up is likely to be much more heavily or exclusively funded by share holders.

Also the start up is likely not to pay a dividend, because for a start it's probably not making any profit, but even if it is and could pay a dividend, in this situation borrowing is unavailable or very expensive and this is a rapidly growing business that wants to keep its hands on all the cash it can to accelerate itself.

Once it starts making money of course a start up is on its way to making the transition, it becomes able to borrow money at sensible rates, it becomes bigger and more valuable on the back of the borrowing.

Another important point is that dividend income is more stable, at least for the mature companies with stable earnings of your scenario, and investors like stability. If all the income from a portfolio has to be generated by sales, what happens when there is a market crash? Suddenly the investor has to pay, where as with dividends, the company pays, at least for a while. If a company's earnings are hit by market conditions of course it's likely the dividend will eventually be cut, but short term volatility should be largely eliminated.

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@PyRulez Hmm, not quite... Normally, a company grows in value (due to profit) for a period, then pays a dividend, thus cutting back some or all of that value again. Gearing (borrowing to shareholder investment ratio) therefore remains relatively stable. As per paragraph 3 of my answer, a policy of no dividend and no borrowing leads to lower borrowing vs the 'market capital' (shares x price) of the company (called lower gearing). Lower gearing is less efficient, especially for the mature stable earnings company the OP enquires about. – Michael Feb 8 at 0:38
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Why is it bad if less of the company's money is loans v.s. assets? Isn't it a good thing to have less debt? – PyRulez Feb 8 at 0:44
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@PyRulez: Debt is cheap, basically. The market reason is that interest on debt is paid before profits are distributed to shareholders. This implies a lower risk. In fact, with the current volume of money printing all around the world, AAA-rated companies currently receive interest on their debt (!!) Not as much as Germany receives on its bonds, though. – MSalters Feb 8 at 12:06
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@Michael yes I also thought about that, because paying out dividends would decrease your WACC, right? And the company has to find the right mix of debt and equity, never paying out a dividend would increase equity and would therefore be costly.. – lukstei Feb 8 at 13:07
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You need to focus on the cost of capital bit, and show why it is true. In what way is the cost of capital cheaper from borrowing from a bank than from shares? Note that this isn't always true, or nobody (rational) would ever use capital markets, and everything would be single proprietorships funded by loans: so explaining why it is true sometimes and false other times is important. – Yakk Feb 8 at 16:22

It comes down to the practical value of paying dividends. The investor can continually receive a stream of income without selling shares of the stock. If the stock did not pay a dividend and wanted continual income, the investor would have to continually sell shares to gain this stream of income, incurring transaction costs and increased time and effort involved with making these transactions.

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The real value of a share of stock is the current cash value of all dividends the owner will receive, plus the current cash value of the final liquidation if any. Since people with different needs may judge the current cash value of an income stream differently, there would be a market basis for people to buy and sell stocks even if everyone could predict all future payouts perfectly.

If shareholders knew that a company wouldn't pay any dividends until it was liquidated in the year 2066, whereupon it would pay $2000/share, then each share would in 2016 effectively be a fifty-year zero-coupon bond with a $2000 maturity value. While some investors would be willing to trade in such an instrument, the amount of money a company could charge for such an instrument would be far lower than the money it could charge for one with payouts that were more evenly distributed through time.

Since the founders of most companies want their companies to be around for a long time, that would mean that shareholders would have no expectation of their shares ever yielding anything of value within any foreseeable timeframe. Even those who would be more interested in share-price appreciation than dividends wouldn't be able to see share prices rise if there wasn't any likelihood of the stock being bought by someone who wanted the dividends.

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Firstly, investors love dividend paying company as dividends are proof of making profit (sometimes dividend can be paid out of past profits too)

Secondly, investor cash in hand is better than potential earnings by the company by way of interest. Investor feels good to redeploy received cash (dividend) on their own

Thirdly, in some countries dividend are tax free income as tax on dividends has already been paid. As average tax on dividend is lower than maximum marginal tax; for some investor it generates extra post tax income

Fourthly, dividend pay out ratio of most companies don't exceed 30% of available fund for paying (surplus cash) so it is seen as best of both the world

Lastly, I trust by instinct a regular dividend paying company more than not paying one in same sector of industry

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Paying out dividends and financing new projects with debt also lessens the agency problem.

The consequences of a failed project are greater when debt is used, so the manager now has a greater incentive to see that the project is a success. This, in addition to the paid divided is a benefit to the shareholder. If equity wasn't paid out and instead used for the project then the manager may not be so interested in its success. And if it's a failure then the shareholders are worse off.

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Is there a reason why my answer has been down voted? I'm describing the agency problem of debt. – Martinn Feb 9 at 3:44

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