What is the link between higher dividend payouts and lower cost of equity?

The link between higher dividend payouts and lower cost of equity can be explained through the risk-return relationship:

1. Risk Perception and Required Returns

   • Investors view dividend payments as less risky than potential capital gains
   • When risk is perceived as lower, investors accept lower returns
   • Cost of equity = Required Return by investors

2. Mathematical Connection

   • Cost of equity = Risk-free rate + (Beta × Market risk premium)
   • When perceived risk decreases, beta effectively decreases
   • Lower beta leads to lower cost of equity

Example:
If Company A pays high dividends:

• Investors might accept 8% return due to certainty

If Company B pays no dividends:

• Investors might demand 12% return due to uncertainty

Therefore, Company A's cost of equity (8%) < Company B's cost of equity (12%)

This relationship occurs because investors "price in" the certainty of cash flows, requiring lower risk premiums for predictable dividend payments.