Even putting aside taxes, why should a firm EVER pay dividends? Suppose it has debt. Then it could retire the debt instead. Paying dividends incurs transaction costs, as does paying interest on debt, and obeying debt covenants. And because of bankruptcy costs, debt is more costly than equity.

Suppose instead that the firm is shrinking, and has no need to retain earnings for investment. Then, the simplest thing is for the firm to put its retained earnings in the bank. Investors won't care, whether they are diversified or not.

Do the investors need cash flow? Then allow them to have a regular stock-selling program. This could even be automatated.

So the only reasons to pay dividends are fear of allowing the managers to control free cash flow and signalling. Note that this is a reason the investors might want the firm to have debt too.

[ http://php.indiana.edu/~erasmuse/w/03.06.28a.htm ]

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