Paying of Dividends by the Firms - Essay Example

?Does it matter whether or not firms pay dividends? Why? Introduction Generally companies pass on a fixed percentage of their net profit to their stakeholders in reward to the investment risk taken by investors. Dividend is the key catalyst that persuades shareholders to purchase stakes of an organisation. A potential investor critically evaluates the rate of dividend paid by the firm before purchasing the firm’s shares. From a company perspective, dividend is a liability and is paid if anything is left after all creditors are paid off. However, it seems that some companies do not pay dividends even though they are run profitably. Those companies use that undistributed earnings to reinvest in the business and thereby increase the size of the organisation. Evidently, this practice may adversely affect the financial interests of company shareholders. However, the current market position of the firm particularly influences the implications of non-payment of dividends on the business. This paper will specifically discuss what happens whether or not firms pay dividends. Why some companies pay dividends while some others do not? Undoubtedly, a company tends to pass its earnings to shareholders as remuneration for their investments and hence to retain their interests in the company. When an organisation pays attractive dividends, existing shareholders can significantly gain from their investments. It forces shareholders to stay with the company, and the payment of dividends may also assist the company to attract new potential stakeholders (‘Investor Relations’ 2010). It is clear that dividends paid for a fiscal period is appeared on the consolidated balance sheet prepared at the end of that period. Investors mainly scrutinise current dividend rates so as to decide whether or not to purchase the stocks of the firm. Usually, if investors find that the company offers poor dividend rates, they would not be much interested in investing in that firm. It must be noted that the price of a share is greatly affected by the demand for that particular share in the stock market. Thus, poor dividend rates and non-payment of dividends may cause the firm’s stock prices to decline. Evidently, no company would be willing to accept a decline in its share prices. Therefore, today many of the companies strive to meet its investors’ interests and to attract new potential investors by paying attractable dividends to stockholders. In contrast, rapidly growing concerns would keep maximum money with them so as to promote further growth. Hence, those concerns would not pay dividends. Even a mature organisation which believes that it has further growth potential may choose to reinvest its earnings into the business. Companies that do not pay dividends may use the saved money to invest in a new project, acquire new assets, repurchase their shares that have been sold to outsiders, or even to buy out a running company. Many firms avoid paying dividends to eliminate the huge expenses of issuing new stocks. By keeping their full earnings with them, companies can get rid of the risk of raising funds to meet their various needs. Does it matter whether or not firms pay dividends? The implications of payment or non-payment of dividends on the business may vary according to the investors’ actual investment interests. If the business is still rapidly growing and the investor has long term interests in the company, then non-payment of dividends would not matter. More precisely, when an investor aims at high rates of returns on his investment in the long term, he would be willing to sacrifice his short term financial interests for the long term growth of the firm. As discussed already, the reinvestment of earnings in the business would greatly assist a growing organisation to fuel its business growth. Therefore, a financially sound investor would support reinvestment of profits for the further growth of the business. From a tax perspective, non-payment of dividends can better serve the financial interests of the shareholders in spite of the fact that dividends have tax advantages (Krantz 2011). In countries like United States, dividends are considered as ordinary income and hence they are taxable to shareholders as ordinary income (tradelog). It implies that the tax rate an investor needs to pay on dividend will be the same as his marginal tax rate. As of 2012 regulations, marginal tax rates can be a high of 35%. Under such circumstances, investors can avoid huge tax payments by reinvesting their earnings in the business. Since investors are not taxed on increases in stock prices until the stock is sold, the money grows tax-deferred and the capital gains tax is more favourable than the regular income tax (Sullivan 2013). Another reason why investors support non-payment of dividends is that dividends are subjected to double taxation (Holland 1962). First, the company needs to pay taxes on its revenues; second, shareholders are also taxed on the dividend payout (ibid). As a result, a stockholder loses a significant percent of his income in taxes. In order to avoid such financial losses, a shareholder may reinvest his earnings in the business. However, taxation on dividends is more favourable in countries like UK. “Income from ordinary dividends is taxed more favourably in the UK than interest on cash savings or fixed interest such as corporate bonds or gilts” (Monevator 2009). Market analysts opine that there is a growing group of investors who wish to reinvest their earnings in the business for tax reasons. Referring to Killman (2012), most of the multinational corporations and other large companies are yet to recover from the impacts of the recent global recession. Those firms are badly in need of huge amounts of funds to strengthen their market position and to regain their corporate reputation (ibid). Hence, shareholders who have long term interests in the firm would not be frustrated by the management’s decision to reinvest the firm’s earnings in the business and hence to improve its competitiveness. At the same time, shareholders of mature companies or shareholders having short term financial interests may be hurt by non-payment of dividends. It is clear that dividend is the only real return than an investor receives when he purchases shares of a firm (Riddix, n. d.). One of the major benefits of paying dividends is that it offers consistent realised income to investors on a quarterly basis (ibid). It is obvious that capital gains are not passed on to shareholders until they actually sell their shares. In addition, a drop in stock price can eliminate the capital gains realised. Data indicate that stock prices of many companies have dropped over the last decade and their shareholders would have actually earned no income on their investments if they had not been paid dividends. According to some market analysts, the level of uncertainty in the financial market is very high in the current economic context. Therefore, many stockholders want their companies to pay dividends annually so as to reduce risk possibilities to some extent. Generally, a firm that avoids paying dividends may be unfavourably evaluated by investors and this situation would end up in a decline in the firm’s stock prices. Evidently, stock price declines would adversely affect the firm’s market competitiveness. Since dividend payment is a sign of the company’s financial strength and the management’s positive expectations for future earnings, it can notably motivate shareholders. In the view of some experts, periodical dividend payments directly reflect a firm’s financial stability and hence this strategy can attract new potential investors (Al- Yahyaee et al 2011). As Skinner (2012) claims, regular dividend payments may benefit investors to purchase more shares of the firm and thereby improve their ownership in the business. This strategy may also aid investors to increase their long term capital gains. Similarly, some investors may wish to be paid dividends regularly in order to use that money to invest in more profitable ventures. Those groups of investors would be dissatisfied if companies refuse to pay dividends periodically. When companies continuously reinvest their earning in the business, shareholders obtain no financial incentives for a longer period and therefore they may become inactive. Hence, paying dividends periodically is a better strategy to keep investors active and to ensure their involvement in the firm’s market expansion activities. Finally, shareholders of a mature company may not support non-payment of dividends because such a business concern cannot significantly improve its profitability by reinvesting the earnings in the business. Conclusion From the above discussion, it is clear that non-payment of dividends may or may not affect the business according to the long term interests of the shareholders. Shareholders of a fast growing organisation may be willing to remain with the company even though they are not paid dividends periodically. Since such a business has extreme future growth potential, stockholders will be happy to reinvest their money in the business and hence to maximise their earnings in the long term. Since dividends are subjected to double taxation, non-payment of dividends is favourable for investors from a tax perspective. At the same time, dividends are only the real income paid to shareholders in reward to their risky investments. In the current unpredictable business environment, many of the investors do not like to risk their money by reinvesting in the business. Periodical dividend payment is beneficial for investors to buy more stocks of the company or to invest in more potential business ventures. Finally, regular dividend payment reflects an organisation’s financial stability, which in turn is a key to improve share prices and corporate reputation. References Al-Yahyaee, K. H., Pham, T. M. and Walter, T. S. (2011) ‘Dividend smoothing when firms distribute most of their earnings as dividends’, Applied Financial Economics, 21:1175–1183. Holland, D. M. (1962) ‘Dividends Under the Income Tax’, UMI. [online] Available at: [accessed 5 April 2013]. ‘Investor relations’, London stock exchange, (2010), [online] Available at: [accessed 5 April 2013]. Killman, A. (2012) ‘The Falling Profitability of U.S. Multinational Corporations Abroad’. [online] Available at: [accessed 5 April 2013]. Krantz, M. (2011) ‘Companies that pay no dividends may be good for tax reasons’, USA Today, June 30 [online] Available at: [accessed 5 April 2013]. Monevator. (2009) ‘How UK dividends are taxed’. [online] Available at: [accessed 5 April 2013]. Riddix, M. (n.d.) ‘Why Dividends Are Important To The Portfolio Of Every Investor’. [online] Available at: [accessed 5 April 2013]. Skinner, D. J. (2012) ‘Why U.S. Companies Continue to Pay Dividends’, Bloomberg, [online] Available at: [accessed 5 April 2013]. Sullivan, P. (2013) ‘The 1040 Blues’, New York Times, Feb 11. [online] Available at: [accessed 5 April 2013]. Tradelog. Cash Dividends. [online] Available at: [accessed 5 April 2013]. Read More