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Dividend Policy Theory

We start our coverage of dividend policy theory with three extreme positions, labeled "basic views." These serve as benchmarks for thinking about the importance of dividend policy. They are all based on assumptions that leave out important pieces to the dividend puzzle. So after we cover them, we will proceed by taking into account some other factors that will help to "improve our thinking."

Three basic views

The three basic (and rather extreme) views of dividend policy are: dividends are irrelevant, higher dividends are always better than lower dividends, and lower dividends are always better than higher dividends. All of these views deal with how an investor is to receive her or his return. Stock returns come in two forms: dividend yield and capital gains through price appreciation. More dividends means less capital gains (since the price falls by the amount of the dividends), and leaving the money in the firm results in a higher stock price than if the money were paid out as dividends. So which do you want, dividend yield or capital gains? Let’s look at the way each theory answers this question.



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