Paying Dividends

The Motley Fool covers how hurdle rate can effect which projects companies choose to fund. A direct effect of lowering interest rates is to lower the hurdle rate for companies to fund more projects. This helps to stimulate the economy.

The truth is that dividends require a successful company to make more efficient use of its capital. For example, let's assume a company called DivPayer Corp (Ticker: CHEK) is doing very well, generating a great deal of free cash flow from operations.

DivPayer is currently evaluating three projects that are available for investment. Projects A, B, and C offer returns of 10%, 8%, and 4% respectively. The fact that DivPayer must pay out a cash dividend each quarter means that it only has enough free cash to invest in two of the three projects.

In this example, DivPayer would choose projects A and B because of their higher returns. A company that pays no dividend, however, may have enough funds left over to also invest in project C, despite it being an inferior investment.

This is a simple example, but you'd be surprised at how accurately it can depict a company's decision-making process. The projects available to a given firm will generally have diminishing returns, and companies that pay a dividend are less likely to choose inferior projects simply because they have the money lying around to invest in them.