Dividend Policy

Stable dividend policy: the company pays a consistent, predictable dividend that grows gradually over time, regardless of short-term earnings fluctuations. Most large-cap companies follow this approach because investors value predictability. Residual dividend policy: dividends are paid only from leftover earnings after all positive-NPV projects are funded. This is theoretically optimal but leads to volatile payouts. Hybrid policy: a base stable dividend plus special dividends when earnings are exceptionally strong. This balances predictability with flexibility.

Dividends are taxed as ordinary income in the year received; buybacks defer taxes until shares are sold (capital gains). Dividends signal stability and confidence in recurring cash flows; buybacks signal management believes shares are undervalued. Dividends create a 'sticky' expectation — cutting a dividend is viewed very negatively by the market. Buybacks are discretionary and can be paused without stigma. In practice, most large companies use both: a base dividend for income-oriented investors and buybacks for additional capital return.

Modigliani and Miller argued that in a perfect market (no taxes, no transaction costs), dividend policy is irrelevant to firm value — shareholders can create 'homemade dividends' by selling shares. In reality, taxes, signaling effects, and clientele effects make dividends matter. The 'bird in the hand' theory argues investors prefer dividends because they are certain, while future capital gains are not. Agency theory suggests dividends reduce the cash available for managers to waste on poor investments.