Investor Preference for Dividends- If taxes and transaction costs are ignored, dividend and capital receipts should be perfect substitutes. Yet there appears to be a strong preference for dividends. Why? Explanations are based on the behavioral principles of self-control and aversion for regret. In essence argument is that investors have a preference for dividends due to behavioral reasons. Hence, dividends and capital receipts are not perfectly substitutable.
Information Signaling- management often has significant information about the prospects of the firm that it cannot (or prefers not to) disclose to investors. The information gap between management and shareholders generally causes stock prices to be less than what they would he under conditions of information symmetry. According to signaling theory, these firms need to take actions that cannot be easily imitated by firms that do not have such promising projects. One such action is to pay more dividends, Increasing dividends suggests to the market that the firm is confident of its earning prospects that will enable it to maintain higher dividends in future as well. By the same token, a decrease in dividends is perceived as a negative signal by the market because firms are reluctant to cut dividends.
Clientele Effect- Investors have diverse preferences some want more dividend income; others want more capital gains; still others want a balanced mix of dividend income and capital gains. Over a period of time, investors naturally migrate to firms which have a dividend policy that matches their preferences. The concentration of investors in companies with dividend policies that are matched to their preferences is called the clientele effect. The existence of a clientele effect implies that (a) firms get the investors they deserve (b) it will be difficult for a firm to change an established dividend policy.
Agency Costs If shareholders have complete faith in the integrity and rationality of management, there is no reason why a company that has profitable investment opportunities should pay any dividend. In reality, however, shareholders rarely consider management as a perfect agent. They are concerned that management may squander money over uneconomic projects. And, that is when the relevance of dividends lies. Several scholars have argued that dividends can mitigate agency costs.
Other reasons include:
- Bird in the Hand Theory
- Temporary Excess Cash