We often hear that so and so company has a good dividend yield and hence is a good buy. When a company is paying dividend after coughing up dividend distribution tax, it implies that the company is unable to utilize the cash to generate higher returns and/or the companies doesn't have enough ideas to expand their business. If a company does not pay dividend and utilizes it for returns, then certainly that will reflect on its market price. So why people run behind such high dividend paying companies?
It depends on the internal rate of return generated by the company and the prevailing real rate of return available to a "normal" shareholder. Companies in early growth stages (working in less competitive or untapped arenas) with significant scope for sales (thus profit) expansion will naturally prefer to retain reserves, because the average shareholder earns less through dividends than what he could earn if the amount is reinvested back into the business (adjusted for present value and liquidity premium). Vice versa.
Secondly, it is known fact that debt is a great thing to leverage return on equity. Here is a simple example. Suppose there are 2 identical companies which have everything same with cost of setting up and running the company being Rs 1000 and operating profit being 20%, Rs 200. One is debt free with equity of Rs 1000 and another with Rs 400 of equity and rest Rs 600 of debt at 15% annual interest. Here is the comparison.
Cost of project: Rs 1000
All Equity Rs 400 equity + 600 debt @15%
PBIDT: 200 200
Interest: 0 90
PBT: 200 110
Tax @40%: 80 44
PAT: 120 66
ROE: 12% 16.5%
Clearly, the second company with debt is better since it gives higher return on equity of 16.5%. So, why there is so much of fuss about a company being debt free since being debt free simply means it is unable to leverage to give higher returns.
It again depends on the type of company using debt. Companies dealing in a cyclical,organized, market will face significant fluctuations in earnings over a given (long) period if leverage employed is more than necessary. A sudden and drastic drop in price of the commodity and lead to the bankruptcy of the company.
All Equity .................................. Rs 400 equity + 600 debt @15%
PBIDT: -200 .................................. -200
Interest: 0 ................................ -90
PBT: -200 ............................... -290
Tax @40%: 0 ............................... 0
PAT: -200 {CF} .............................. -290{CF}
ROE: -20% ................................... -72.5%
Equity (Beg): 1000 ......................... 400
Loss : 200 ......................... 290
Equity End : 800 .......................... 110
Consider year 2:
All Equity(800} Rs 400 equity + 600 debt @15%(174)
PBIDT: 200 .......................................... 200
Interest: 0 ......................................... (90)
PBT: 200 ........................................ 110
Loss CF: (200) ........................................ (290) {CF of -180}
Tax @40%: 0 ....................................... 0
PAT: 200 .......................................... 110
Final Equity: 1000 ......................................... 220
In scenario 1, the result would be a break even whereas in scenario 2, the result would be a drop of 45%. One more such a cycle could wipe out the company in scenario 2