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utility companies should pay dividends: agree or not?

It has been argued by a journalist that utility companies should not be allowed to pay cash dividends. His reasoning is that it would reduce their need to raise external capital, thereby reducing their transaction costs and ultimately lowering their cost of capital. These savings would ultimately be passed on to customers in the form of lower utility rates. Stockholders would receive capital gains instead of the cash dividends and because of the lower tax rates and deferrals associated with capital investments; it would ultimately lower their taxes. So it is a win-win for all parties involved.

Is this a logical argument? Explain your reasoning.


Solution Preview

This argument misses a few important facts.

First, the journalist does not seem to understand the timing of cash inflows and cash outflows. The journalist says that utilities should use their cash flow for new investments rather than paying dividends. While this might reduce borrowing costs, the cash flow happens as an annuity (steady stream over time rather than large periodic windfalls) and capital requirements at utilities tend to be large and spread far apart. So, the cash would be idle and building for YEARS ...

Solution Summary

This argument misses some important ideas. In four paragraphs, this response will get you thinking about what else must be considered in a dividend decision for utilities. The discussion is in everyday language suitable for a novice.