Retained Earnings or Cash Dividends?
From the firm’s perspective, net income can be retained and reinvested or else paid out as cash dividends. The opportunity cost of one alternative is the other alternative. We already saw this when covering the cost of capital.
Remember the cost associated with retained earnings (internal equity)? It was the going rate of return on the firm’s stock, since that is what we expect that the stockholders could earn if they were paid cash dividends that they would reinvest. A firm that cannot earn the going rate of return on its investments should pay out its money so the investors can earn that rate of return elsewhere.
Likewise, if the firm pays cash dividends it gives up any opportunities present with earnings retention. A company with great growth opportunities that are expected to earn more than the company’s cost of capital would be giving up stockholder wealth increases if it paid cash dividends.
Dividend Policy Theory
We start our coverage of dividend policy theory with three extreme positions, labeled "basic views." These serve as benchmarks for thinking about the importance of dividend policy. They are all based on assumptions that leave out important pieces to the dividend puzzle. So after we cover them, we will proceed by taking into account some other factors that will help to "improve our thinking."
Three basic views
The three basic (and rather extreme) views of dividend policy are: dividends are irrelevant, higher dividends are always better than lower dividends, and lower dividends are always better than higher dividends. All of these views deal with how an investor is to receive her or his return. Stock returns come in two forms: dividend yield and capital gains through price appreciation. More dividends means less capital gains (since the price falls by the amount of the dividends), and leaving the money in the