Question

Describe the dividend theories:

1. dividend irrelevance

2. dividend preference

3. tax effect theory

4.clientele effect

5. signaling hypothesis

Answer 1

1. Dividend irrelevance: This theory states that investors don't give much value to dividends as they have the option to sell the company's stock if they are need of cash. So, according to this theory, a company's dividend policy will have little or no effect on the perceived value of that company.

2.Dividend preference: This is in complete contrast to dividend irrelevance theory and states that investors prefer dividend paying stocks because of the inherent uncertainty in the price of a stock.

3.Tax effect theory: This theory states that investors prefer companies that don't pay dividends because of tax reasons. Dividends are taxable as soon as they are received whereas taxes on capital gains can be deterred till the investor actually decides to sell the stock.

4.Clientele effect: This theory tries to explain the movement in a company's stock price in response to changes in its policies. According to this theory, there are different types of investors that invest in a company's stock and they have different expectations from the company. Some want the company to not declare dividends and focus on future growth whereas others prefer dividends. So, whenever a company announces a change in its policy, stock price fluctuates as some investors seek to exit whereas other seek to invest in it.

5.Signaling hypothesis: According to this theory, a company's dividend policy provides signals regarding its future growth prospects. A company announcing an increase in dividend payout is an indication of positive future prospects.