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Look anywhere on the web and you're bound to find information on how dividends affect stockholders: the information ranges from a consideration of steady flows of income, to the proverbial "widows and orphans", and to the many different tax benefits that dividend-paying companies provide. An important part missing in many of these discussions is the purpose of dividends and why they are used by some companies and not by others. Before we begin describing the various policies that companies use to determine how much to pay their investors, let's look at different arguments for and against dividends policies. Arguments Against Dividends First, some financial analysts feel that the consideration of a dividend policy is irrelevant because investors have the ability to create "homemade" dividends. These analysts claim that this income is achieved by individuals adjusting their personal portfolio to reflect their own preferences. For example, investors looking for a steady stream of income are more likely to invest in bonds (whose interest payments don't change), rather than a dividend-paying stock (whose value can fluctuate). Because their interest payments won't change, those who own bonds don't care about a particular company's dividend policy. The second argument claims that little to no dividend payout is more favorable for investors. Supporters of this policy point out that taxation on a dividend is higher than on capital gain. The argument against dividends is based on the belief that a firm who reinvests funds (rather than pays it out as a dividend) will increase the value of the firm as a whole and consequently increase the market value of the stock. According to the proponents of the no-dividend policy, a company's alternatives to paying out excess cash as dividends are the following: undertaking more projects, repurchasing the company's own shares, acquiring new companies and profitable assets, and reinvesting in financial assets. Arguments For Dividends In opposition to these two arguments is the idea that a high dividend payout is more important for investors because dividends provide certainty about the company's financial well being; dividends are also attractive for investors looking to secure current income. Also, there are many examples of how the decrease and increase of a dividend distribution can affect the price of a security. Companies that have a long-standing history of stable dividend payouts would be negatively affected by lowering or omitting dividend distributions; these companies would be positively affected by increasing dividend payouts or making additional payouts of the same dividends. Furthermore, companies without a dividend history are generally viewed favorably when they declare new dividends. Dividend-Paying Methods Now, should the company decide to follow either the high or low dividend method, it would use one of three main approaches: residual, stability, or a compromise between the two. Residual Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects. As a result, dividend payments can come out of the residual or leftover equity only after all project capital requirements are met. These company's usually attempt to maintain balance in their debt/equity ratios before making any dividend distributions, which demonstrates that such a company decides upon dividends only if there is enough money leftover after all operating and expansion expenses are met. For example, let's suppose that a company named CBC has recently earned $1,000 and has a strict policy to maintain a debt/equity ratio of 0.5 (one part debt to every two parts of equity). Now, say this company had a project with a capital requirement of $900. In order to maintain the debt/equity ratio of 0.5, CBC would have to pay 1/3 by using debt ($300) and 2/3 ($600) by using equity. In other words the company would have to borrow $300 and use $600 of its equity to maintain the 0.5 ratio, leaving a residual amount of $400 ($1,000-$600) for dividends. On the other hand, if the project had a capital requirement of $1,500, the debt requirement would be $500 and the equity requirement would be $1,000, leaving zero ($1,000-$1,000) for dividends. Should any project require an equity portion that is greater than the company's available levels, the company would issue new stock. Stability The fluctuation of dividends created by the residual policy significantly contrasts the certainty of the dividend stability policy. With the stability policy, companies may choose a cyclical policy that sets dividends at a fixed fraction of quarterly earnings, or they may choose a stable policy whereby quarterly dividends are set at a fraction of yearly earnings. In either case, the aim of the dividend stability policy is to reduce uncertainty for investors and to provide them with income. Suppose our imaginary company CBC earned the $1,000 for the year (with quarterly earnings of $300, $200, $100, $400). If CBC decided upon a stable policy of 10% of yearly earnings ($1,000*10%), it would pay $25 ($100/4) to shareholders every quarter. Alternatively, if CBC decided upon a cyclical policy, the dividend payments would adjust every quarter to be $30, $20, $10 and $40 respectively. In either instance, company's following this policy are always attempting to share earnings with shareholders rather than searching for projects to invest excess cash. Hybrid The final approach is a combination between the residual and stable dividend policy. Using this approach, companies tend to view the debt/equity ratio as a long-term rather than a short-term goal. In today's markets, this approach is commonly used by companies that pay dividends. As these companies will generally experience business cycle fluctuations, they will generally have one set dividend, which is set as a relatively small portion of yearly income and can be easily maintained. On top of this set dividend, these companies will offer another extra dividend paid only when income exceeds general obtained levels. | 
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