Reading: Why do Firms Pay Dividends?

A first rather obvious reason for why firms pay dividends is that there could be investors who have a desire for current income. For example:

• Retired individuals who live on a fixed income
• Endowments or trusts that are limited to spending income and cannot spend capital
• Pension funds that have recurring financial obligations
• etc.

In the perfect world that we have assumed at the beginning of this module, these considerations are irrelevant. The reason is that we have assumed frictionless capital markets, in which investors can freely trade. In such a world, investors can sell part of their stockholdings if they desire current income, and they can reinvest dividends if they have no desire for current income. Because there are no taxes and no transaction costs, these trades are all value neutral. So, in the perfect world, investors can factually design their own payout policy, which is why this behavior is generally referred to as "homemade dividends." 

In the real world, there are transaction costs associated with stock sales (e.g., brokerage fees, bid-ask spreads, management time). Trading is therefore not free of charge. Moreover, as we have discussed at length in the preceding section, there are also taxes. Therefore, for most investors, "homemade dividends" are considerably more extensive than direct cash payouts from the firm.