Dividend is the portion of the company’s profit that is distributed to the shareholders. Dividend policy refers to the decision taken by the management regarding the amount of profit to be distributed among shareholders and the time and mode of such distribution. There are several theories of dividend that explain the factors affecting the dividend policy of a company. In this essay, we will discuss the different theories of dividend and comment on which theory is more suited to the Indian business environment.
Theories of Dividend:
1. Walter’s Model: Walter’s model is based on the assumption that the market price of a share is directly related to the earnings per share (EPS) and the cost of capital. The model suggests that the value of the firm and the dividend payout ratio are inversely related. According to this model, the firm should follow a high dividend payout ratio if the return on investment is more than the cost of capital, and a low dividend payout ratio if the return on investment is less than the cost of capital.
2. Gordon’s Model: Gordon’s model assumes that the market price of a share is directly related to the dividend payout ratio and the cost of capital. The model suggests that the value of the firm and the dividend payout ratio are directly related. According to this model, the firm should follow a high dividend payout ratio if the cost of capital is less than the growth rate of earnings, and a low dividend payout ratio if the cost of capital is more than the growth rate of earnings.
3. Modigliani-Miller Model: Modigliani-Miller Model assumes that the value of the firm is not affected by the dividend policy. The model suggests that the market value of the firm is determined by the earnings potential and the risk associated with the firm. According to this model, the dividend policy is irrelevant to the investors, and the firm can follow any dividend policy as long as it does not affect the value of the firm.
4. Bird-in-Hand Theory: The Bird-in-Hand Theory assumes that investors prefer dividends to capital gains because they are more certain. The theory suggests that the value of the firm is directly related to the dividend payout ratio. According to this theory, the firm should follow a high dividend payout ratio to attract more investors and increase the value of the firm.
5. Tax Preference Theory: The Tax Preference Theory assumes that investors prefer lower dividend payout ratios because of the tax advantages of capital gains. The theory suggests that the value of the firm is inversely related to the dividend payout ratio. According to this theory, the firm should follow a low dividend payout ratio to attract more investors who are interested in capital gains.
Which Theory is more Suited to the Indian Business Environment?
The Indian business environment is unique in many ways, and the dividend policy of a company is affected by several factors such as tax laws, corporate governance, and ownership structure. In the Indian context, the Walter’s Model and the Bird-in-Hand Theory are more suited to the business environment.
The Walter’s Model is more relevant to the Indian business environment because the cost of capital is high, and the return on investment is often less than the cost of capital. The Indian economy is characterized by high inflation, high interest rates, and limited availability of credit, which increases the cost of capital for companies. Therefore, companies in India should follow a low dividend payout ratio to retain earnings and reinvest in the business to generate higher returns.
The Bird-in-Hand Theory is also relevant to the Indian business environment because Indian investors prefer high dividend payouts due to the lack of trust in the corporate governance system. Indian investors often view dividends as a way to compensate for the lack of transparency and accountability in the management of companies.
Another theory of dividend is the bird-in-hand theory, which suggests that investors prefer dividends over capital gains as they perceive dividends to be less risky than potential capital gains. This theory argues that investors view dividends as tangible cash payments while capital gains are uncertain and dependent on future market conditions. Therefore, companies that pay high dividends are seen as less risky and more attractive to investors.
Finally, the clientele effect theory argues that companies should cater to the dividend preferences of their shareholders. This theory suggests that companies attract investors with specific dividend preferences and that changes in dividend policies may lead to changes in the composition of the shareholder base. Companies should, therefore, maintain a consistent dividend policy to retain their existing shareholders.
In the Indian business environment, the relevance of these dividend theories may vary depending on factors such as industry, company size, and shareholder preferences. For example, in industries such as FMCG or pharmaceuticals, where companies have stable earnings, the bird-in-hand theory may be more applicable as investors may prefer steady dividend payments over potential capital gains. In contrast, companies in the technology sector may prioritize growth and reinvestment, making the residual theory more relevant.
Additionally, the dividend preferences of Indian shareholders may also impact the choice of dividend theory. Historically, Indian investors have shown a preference for high dividend-paying companies, which may align with the bird-in-hand theory. However, with the emergence of a new generation of investors and changing market conditions, there may be a shift towards growth-oriented investments, making the residual theory more relevant.
In conclusion, the choice of dividend theory depends on various factors, and there is no one-size-fits-all approach. Companies should evaluate their business requirements, industry conditions, and shareholder preferences before deciding on their dividend policy. Additionally, they should regularly review their dividend policies to ensure that they remain relevant and in line with market conditions and investor preferences.
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