MM said that dividend policy is irrelevant because it does not affect shareholder value. MM did not say that payout should be random or erratic; for example, it may change over the life cycle of the firm. A young growth firm pays out little or nothing, retaining cash flow for investment. As the firm matures, positive-NPV investment opportunities are harder to come by and growth slows down. There is cash available for payout to shareholders. In old age, profitable growth opportunities disappear, and payout may become much more generous.
Of course, MM assumed absolutely perfect and efficient capital markets. In MM’s world, everyone is a rational optimizer. The right-wing payout party points to real-world imperfections that could make high dividend payout ratios better than low ones. There is a natural clientele for high-payout stocks, for example. Some financial institutions are legally restricted from holding stocks lacking established dividend records. Trusts and endowment funds may prefer high-dividend stocks because dividends are regarded as spendable “income,” whereas capital gains are “additions to principal.”
There is also a natural clientele of investors, such as the elderly, who look to their stock portfolios for a steady source of cash.[1] In principle, this cash could be easily generated from stocks paying no dividends at all; the investor could just sell off a small fraction of his or her holdings from time to time. But it is simpler and cheaper for the company to send a quarterly check than for its shareholders to sell, say, one share every three months. Regular dividends relieve many of its shareholders of transaction costs and considerable inconvenience.
Some observers have appealed to behavioral psychology to explain why we may prefer to receive those regular dividends rather than sell small amounts of stock.[2] We are all, they point out, liable to succumb to temptation. Some of us may hanker after fattening foods, while others may be dying for a drink. We could seek to control these cravings by willpower, but that can be a painful struggle. Instead, it may be easier to set simple rules for ourselves (“cut out chocolate,” or “wine with meals only”). In just the same way, we may welcome the selfdiscipline that comes from spending only dividend income, and thereby sidestep the difficult decision of how much we should dip into capital.
Clearly, some clienteles of investors prefer stocks with regular and stable cash dividends. These investors might be willing to pay more for stocks of companies that paid out cash by dividends rather than repurchases. But do they have to pay more? Corporations are free to adjust the supply of dividends to demand. If they could increase their stock prices simply by shifting payout from repurchases to cash dividends, they would presumably have done so already. The investors who prefer cash dividends already have a wide choice of dividend-paying stocks. If the supply of such stocks is sufficient to satisfy those investors, then additional firms have no incentive to switch from repurchases to cash dividends. If this is indeed the outcome, the middle-of-the-road party wins, even if the rightists have correctly identified clienteles that prefer cash dividends.
Payout Policy, Investment Policy, and Management Incentives
Perhaps the most persuasive argument in favor of the rightist position is that paying out funds to shareholders prevents managers from misusing or wasting funds.[3] Suppose a company has plenty of free cash flow but few profitable investment opportunities. Shareholders may not trust the managers to spend retained earnings wisely and may fear that the money will be plowed back into building a larger empire rather than a more profitable one. In such cases, investors may demand higher dividends not because these are valuable in themselves, but because they encourage a more careful, value-oriented investment policy.
Cash-cow corporations may be reluctant to let go of their cash. But their managers know that the stock price is likely to fall if investors sense that the cash will be frittered away. Particularly for top managers holding valuable stock options, this threat of a falling stock price provides an excellent incentive to pay out the surplus cash.
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