A question which has been haunting me for the last two days. Why should companies pay dividends? The background is that a lot of companies in India are flush with funds. (Bajaj, Reliance, Infy, Hero Honda). I have tried to provide some kind of explanation of the same.
M&M (Miller&Modigliani) argue that the capital structure doesn't have any bearing on the valuation of the firm. In the same breath, i think they also argue that whether a company pays or doesn't pay dividends doesn't affect the valuation of the firm.
But the only problem with his argument is that he assumes that the market is perfect. ( no taxes, no imperfections et al).
My take on it:
a) There is an associated cost of equity associated with issued shares. (People wont invest in a company until they are expect a certain rate of return). So if say the excess capital is given as extra salary to employees, then the rate of return reduces and the share price gets a hammering. One may ask why should one be worried about the share price? Lot of reasons. Basically as an entrepreneur, you want the market to value your shares efficiently. This is required for future capital financing (both from debt and equity markets), acquisitions(done thro a share swap) or enhance the brand image of the company.
b) If the company is in a high growth phase, then the company can invest the same ( we can see the use of the Discounted cash flow valuation with the impact on growth rate) now in expectation of a good future. So many companies in the IT/technology sector plow back a lot of cash into investments. But normally, the investors are compensated with a share price appreciation rather than a divendend gain.
c) So we are convinced that people who invested in the company should be rewarded with a certain rate of return. Now if you have excess cash, there are traditionally two ways to return the same to the shareholders. One is through a dividend payout and the other is through a share buyback. Normally a share buyback is x% higher than the present share price and the investors get a capital appreciation gain. And the advantage of a share buyback is that it is not taxed. So companies should always be buying back shares rather than giving dividends? But the regulators make sure that the companies dont use this as a proxy for divident payouts. So why do companies buyback shares? If the company has excess cash and it believes that the valuation of its shares is underpriced or it is going to increase further, then it buysback the shares so that in times of capital financing, it can reissue these shares at a higher price. But some companies like Infy dont believe in Share buybacks as it implies that the management has to take a call on the correct price of the share which is not an easy thing.