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Corporate Governance Dividend Issues

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Why do firms pay cash dividends? Why do firms that pay cash dividends follow what is called a constant dollar growth rate policy whenever possible? And, most important, what is the connection, if any, between cash dividends, dividend policy, and corporate governance systems?

The thinking of financial economists about dividend policy and why firms pay cash dividends has evolved in much the same way as their thinking about financing the company. Initially, economists focused on whether any connection existed between dividend policy and the firm's cost of capital or, which is essentially the same thing, its market value. This analysis was carried out under the same perfect capital market assumptions that we noted in the description of financing decisions. But, as empirical evidence about the relationship between firm value and cash dividends began to accumulate, dividend policy increasingly came to be seen as another means of mitigating conflicts of interest among the stakeholders of the firm.

As in the previous chapter, we set up the issues by asking what would be the dividend policy of a company operating in a world in which there were no taxes and no conflicts of interest among the firm's stakeholders. We then introduce the governance problems associated with self-seeking behavior on the part of managers, who have more information about the company than the public shareholders do. We conclude with a brief description of the apparent connection between dividend policy and different corporate governance and national legal systems.

Managers can do two things with current year's earnings: They can distribute them as cash dividends, or they can retain them in the company. If the earnings are retained, management can use them to make additional investments or to pay down debt. The decision to pay down debt is part of the financing decision and is connected to the notion of an optimal capital structure and solving governance problems through the financial structure decision. So, setting aside the “pay down the debt” alternative, when should management retain earnings and reinvest them in the company, and when should management distribute the earnings as cash dividends?
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Document Type: Research Article

Publication date: February 25, 2003

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