Why Do Companies Give Dividends?
Businesses give dividends according to the demand of stockholders or would-be stockholders. Yet it's not easy to reach any firm conclusion why stockholders demand them, or whether that demand is entirely rational.
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Dividends or Capital Appreciation
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If a company didn't pay dividends, its shareholders could expect to receive a profit on their investment only by virtue of capital appreciation, which is selling their shares as they increase in value. Franco Modigliani and Merton Miller in "The Cost of Capital" state that both investors and corporations should be indifferent as to how much of its earnings a corporation pays out in dividends. Whatever the firm doesn't pay out, it retains. That retention should enable the appreciation of the stock's value, and that in turn should have the same effect for the enrichment of investors as would the dividends. However, many ideal-world assumptions are embedded in the proof of Modigliani and Miller's theory. Given more real-world conditions, dividend policy is a matter of concern to stockholders, which in turn makes it a concern of management.
Transaction Costs
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One key assumption is that no transaction costs exist. If capital appreciation will substitute perfectly for a stream of dividends, then investors should be able to sell their stock without frictional costs when they need the cash. To the extent that they do encounter such costs, they may well prefer to instead receive the dividend stream, explains H. Kent Baker in "Dividends and Dividend Policy."
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Psychology
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Some economists have questioned a less explicit premise of the Modigliani and Miller discussion: the neoclassical notion that investors will act rationally, so that if they could get the same results out of capital appreciation that they get out of a dividend stream, they would be indifferent. However, it's possible that a non-rational element exists, a psychological propensity to want the "bird in the hand" rather than the two in the bush. If this is so, then the answer why companies give dividends is that they must please even the non-rational demands of their investors.
Share Repurchases
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Another consideration important to dividend policy is that a corporation will sometimes repurchase shares from it shareholders. This may reduce the transaction costs for those shareholders who want to cash in on their capital appreciation: the company itself offers to do the buying. A natural hypothesis, then, is that firms that buy back shares use the same money to do so that they might otherwise have employed paying dividends. The purchase substitutes for dividends. Yet according to a dissertation submitted by Adam Dunsby to the University of Pennsylvania in 1995, that hypothesis is not confirmed by practice. "Firms that repurchase do not pay less in dividends than comparable firms which do not repurchase." The simple-seeming question of why companies give dividends still has some mystery attached to it.
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