Factors that affect a company’s dividend policy decision include:
- Investors are primarily concerned with the after-tax returns of their investments.
- Differences in tax rates for dividends versus capital gains can materially influence an investor’s stock investment choices.
- In addition, frequent dividends create frequent tax events, while capital gains taxes can be deferred until an investor decides to sell a stock.
- Tax systems affecting dividends can be divided into three general classes:
- Double Taxation System: this occurs in the U.S., where the company pays taxes on its earnings prior to any dividend distribution and investors receiving dividends pay taxes on dividend income.
- Split Rate System: earnings paid as dividends are taxed at different rates from earnings retained by the company.
- Imputation System: companies pay corporate income taxes, but shareholders can subtract the portion of taxes paid by the company from their individual tax bills.
Flotation Costs of Issuing Equity
- When issuing new stock, companies must pay investment banking fees.
- As a result of these costs, firms may hesitate to pay dividends if they anticipate financing needs for upcoming capital projects. In other words it is less expensive for a firm to reinvest its earnings, rather than pay a dividend and face the prospect if issuing new equity.
- Dividend payments reduce a company’s retained earnings, which in turn reduce equity.
- Companies may be constrained by debt covenants from paying dividends if shareholder equity falls below a specified level, for example.
The Clientele Effect
- Investors face different financial situations, which lead to different attitudes toward dividends.
- A key difference across investors is tax status. A high tax bracket individual may not value dividends as much as a tax exempt charity.
- Some institutional investors, such as mutual funds, pension funds, banks, or insurance companies may only buy stocks which have a record of steady dividends, as the equity of these dividend paying companies is viewed as less risky.
- Investor preferences for investing in equity based on dividends is called the clientele effect.