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professor and Goldman Sachs partner Fischer Black argued that because of the US double-taxation structure where corporations rst pay taxes on earnings and then individuals again pay taxes on dividends, both corporations and individuals should prefer no dividends2 Corporations should only return earnings to their shareholders as cash dividends when they do not have projects with reasonable rates of return and their own share prices are high If the share price is low, they should repurchase their own shares Consider Citigroup, a large nancial institution with a market capitalization of about $200 billion in late 2007 Its common stock was among the highest dividend-yielding stocks, paying stockholders 7 percent During 2007, the stock price declined by over 40 percent because the company suffered losses of about $10 billion in its housing-related investments In the wake of Citigroup s decline, CEO Charles Prince had to resign To regain its nancial strength, Citigroup issued $75 billion of convertible securities, yielding 11 percent to the Abu Dhabi Investment Authority By any yardstick, 11 percent is high, in light of the fact that the going rate of interest on 10-year Treasury notes at the time was only 425 percent and the 30-year mortgage rate, about 58 percent Although Citigroup s stock price had declined and the company was forced to raise funds, it continued to pay almost $10 billion a year in dividends It was obvious that Citigroup needed cash in a hurry: The market did not think highly of Citigroup s nancial strength because of the huge losses it had incurred Why did Citigroup not cut its dividends immediately when it was obviously in serious nancial trouble Some have argued that once a company starts paying a dividend, the market expects the company to pay the dividend at regular intervals forever This argument may have some justi cation in normal circumstances, but the logic is questionable in this case Since the company already indicated that it was in nancial trouble and needed to raise funds by issuing preferred stock, a dividend cut would have been a more logical choice than raising equity While Citigroup is an extreme example (and it nally cut its dividend), it is common for corporations to raise equity and pay dividends at the same time Such cases are often examples of poor nancial management Receiving regular dividends is costly to you First, if you own shares in your name, you receive checks every quarter that you then have to
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Dividends: Do They Make Sense in This Day and Age
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take to the bank, spending time on this chore Depositing of dividends can be made automatic if you own shares in a brokerage account, but many people prefer to hold shares themselves because they are safer that way Second, you have to spend more time and effort keeping track of your dividends for tax purposes Finally, you have to pay taxes on these dividends, often at a rate higher than the capital gains tax rate If some shareholders need regular infusions of cash, it is not clear that what they receive in dividends is the right amount for them Shareholders can easily sell a few shares if they need cash Also, shareholders can decide which shares to sell to minimize their tax burden Perhaps some intermediaries and consultants who give advice on dividends earn fees, and that may be one reason most companies continue to pay regular dividends in this day and age So what should you look for in a dividend policy A regular dividend payment from a company that generates regular free cash ows but does not have growth opportunities indicates a company with self-disciplined management In academic nance, this is known as the monitoring role of dividends Because of the commitment to pay regular dividends, such companies are less likely to waste resources and are good candidates for further analysis Costco started in 1983 and used its cash ows for growth until 1994, when it started paying dividends It was a good company to invest in before it paid any dividends and also after it started paying regular dividends If you had focused only on dividend-paying companies, you would have not invested in Costco or for that matter in Berkshire Hathaway A regular dividend payment by itself is not a strong enough variable to characterize a company as a good investment When a company paying regular dividends also raises funds in the nancial markets and the balance sheet is not strong, you should be careful about investing in its stock Dividend payment is just one possible use of free cash ows What is most important is your comfort level with a company s usage of its free cash ows Companies have many choices other than paying dividends: They can undertake new projects, repurchase their own shares, and invest in nancial assets If you are not comfortable with management decisions on its usage of cash ows, especially its investment policy, you should not buy the stock in the rst place If a company has excess cash without a reasonable probability of pro table new projects, it can do what Microsoft did
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