Why Do Companies Pay Dividends On Common Stock ?
Basically when a person buys common stock, he is investing in the company in anticipation that the company will perform well and he will see a good return on his investment. The money that stockholders invest is used to grow the business. |
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However, a company will pay dividend on common stock only if it is able to generate profit and has sufficient free cash flow. Free cash flow refers to the money that company generates from its business less the money spent on capital expenditures. In other words, free cash flow refers to the money that the company has after it has paid all its bills and re-invested the money into the business.
Once the company has free cash flow, it has two options in front of it. It can either use the extra money to invest it back into the business or it can pay dividends to common stock holder. If the company finds a new area of interest, it will put the money back into the business because it feels it will get a better return on this investment. However, at times, the company will not reinvest the free cash flow as it feels that the stockholders will get better return on the money if it pays out the dividends. That is why companies that have low growth invariably end up paying high dividends to common stock holders.
Therefore, one can say that companies pay dividends on common stock because they feel it is the best way of using the surplus money they have.
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