It’s long been known that many investors have a preference for cash dividends. But from the perspective of classical financial theory, this behavior is an anomaly. Here’s why.
It’s perplexing behavior because before taking into consideration what are referred to as “frictions” such as transaction costs and taxes, dividends and capital gains should be perfect substitutes for each other.
Simply stated, a cash dividend results in a drop in the price of the firm’s stock by an amount equal to the dividend. That must be the case unless you believe that $1 isn’t worth $1.
Thus, investors should be indifferent between a cash dividend and a “homemade” dividend created by selling the same amount of the company’s stock. One is a perfect substitute, minus any frictions like transaction costs and taxes that come with the other. Thus, without considering frictions, dividends are neither good nor bad.
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