Question

why would a company pay dividends and also borrow to invest?

Answer 1

There may be various reasons why a company would pay dividends and also borrow to invest. Some of them are enlisted below:

1. When the company's retained earnings are low. This may be because the dividend payment exceeds the company's retained earnings or because, although the retained earnings are greater than the dividend payment, the company wants to retain earnings for other purposes. A company may borrow money to pay a dividend if it has regularly paid dividends in the past and the executives and board of directors determine that forgoing the dividend sends a negative signal about future cash flows of the company. Paying the dividend with borrowed funds, they may believe, signals their confidence that future cash flows will pay off the loan and support a continuing dividend stream.
2. When a company grows rapidly. A paradox of rapidly growing companies is that they may have cash flow problems that a slower-growing company won't. For example, a company may generate new business that requires immediate capital outlays. The positive cash flows from that new business will come in over time and won't be available in the quarter when the dividend is paid. When this happens, it makes sense to borrow the money to pay the dividend and to repay the loan from the projected future cash flows.

3. When profits are sheltered. A company may have ample cash to pay dividends but for tax reasons borrows the money instead. With growing investor pressure for dividends and stock buybacks, the company borrows the money instead. The interest on the loan to return money to investors is low and it is tax-deductible.

4. Sometimes a company borrows money to pay a dividend in a tax year where investors pay lower capital-gains taxes than in a following year when the capital-gains tax will rise.