Question

Paying generous dividends and simultaneously raising new equity capital are commonly observed in financial markets. Issuing new equity requires to pay expensive flotation costs which usually account for more than 10 percent of the new equity capital.   The payout policy seems to be uneconomic and inexplicable because the practice looks like firms raising money from one hand and paying out the same money through the other hand. Dose any economic rationale justify the payout policy adopted by firms?

Answer 1

The dividends are paid on the basis of retained earnings of the company.The existence of flotation costs eliminates the indifference between financing by internal capital and new stock. Financing investments through retained earnings will be preferred to avoid flotation costs and capital leakage. If no other perfect market assumptions have been relaxed, new stock would be issued only after internally generated funds have been exhausted.

According to the residual dividend theory, dividends are paid only if retained earnings are available after financing all acceptable investments.