Theories of Dividend are various conceptual frameworks that attempt to explain how companies make decisions regarding the distribution of profits to shareholders in the form of dividends. These theories have been developed over time by researchers and economists to understand the dividend policy of firms and the factors that influence it. Some of the prominent theories of dividend include:
1. **The Residual Theory of Dividends:** This theory suggests that a company should pay dividends only after meeting all its investment requirements and retaining sufficient funds for future growth. In other words, dividends are paid from the residual profits left after financing all profitable investment opportunities. This theory assumes that companies prioritize reinvesting profits to create more value and pay dividends as a secondary concern.
2. **The Dividend Irrelevance Theory (Modigliani-Miller):** Proposed by Franco Modigliani and Merton Miller, this theory argues that the value of a firm is not affected by its dividend policy. They posited that investors can create their own cash flows by reinvesting dividends, so the decision to pay dividends or retain earnings should not impact the stock price. This theory assumes perfect capital markets, no taxes, and rational investors.
3. **The Bird-in-hand Theory:** Developed by Myron Gordon, this theory suggests that investors prefer dividends over capital gains. Investors view dividends as more certain compared to potential future capital appreciation, which they consider riskier. As a result, a high dividend payout ratio is believed to attract more investors, increasing the demand for the company’s stock and thereby increasing its value.
4. **The Signaling Theory:** This theory, proposed by Bhattacharya, suggests that a firm’s dividend policy can be used as a signal to convey valuable information to the market. For instance, if a company increases its dividends, it may signal that the management believes the firm’s future prospects are positive. Conversely, a decrease in dividends may signal potential difficulties. Investors use these signals to make better-informed decisions.
5. **The Tax Preference Theory:** This theory takes into account the impact of taxes on dividend decisions. It suggests that investors prefer capital gains over dividends due to the difference in tax treatment. In many countries, capital gains are often taxed at a lower rate than dividends. Hence, companies may retain earnings and engage in share buybacks to increase the share price and provide investors with tax advantages.
Now, when considering which theory is more suited to the Indian business environment, it’s essential to take into account the specific economic, legal, and cultural factors in India. As of my last update in September 2021, India’s business environment was characterized by the following key aspects:
1. **Preference for Dividends:** Indian investors, like investors in many Asian countries, often exhibit a preference for dividend income. Dividends are seen as a way for companies to share their profits directly with shareholders, and they are generally viewed positively.
2. **Taxation:** In India, dividends were historically taxed in the hands of both the company and the shareholders (dividend distribution tax and dividend income tax). However, the Indian government made significant changes to dividend taxation in recent years to reduce the burden on investors.
Given these aspects, the **Bird-in-hand Theory** and the **Tax Preference Theory** may be more relevant to the Indian business environment:
– The **Bird-in-hand Theory** aligns with the preference for dividends among Indian investors. If companies pay higher dividends, it may attract more investors, thereby positively impacting their stock prices.
– The **Tax Preference Theory** is relevant considering India’s tax structure. If capital gains are taxed at a lower rate than dividends, companies may be more inclined to retain earnings and rely on share buybacks to provide investors with tax advantages.
It’s worth noting that different companies in India may adopt varying dividend policies based on their individual financial situations, growth prospects, and shareholder preferences. Additionally, the Indian business environment is subject to change, so it’s essential to consider the most current information and regulations when analyzing dividend policies in the country.
