Question

Identify, compare, and contrast the major dividend theories that are discussed in your textbook. Be specific.  
-Dividend Aversion (The Tax Effect Theory)
-The Clientele Effect
-The Residual Dividend Theory
-The Signaling Effect of Dividends
-The Expectations Theory

Answer 1

-Dividend Aversion (The Tax Effect Theory)

This theory arises as a consequence of the higher tax levied on dividends and lower tax levied on capital gains.

Since dividends are taxed at a higher rate than capital gains, investors who are averse to paying higher taxes, will expect companies to pay lower dividends and that way maximize capital gains. In order to satisfy the stockholders, a company may have a policy of paying much lower dividends, especially where the tax rates on dividend and capital gains are vastly different.

-The Clientele Effect

This theory holds that there would be several group of stockholders, each group having a different requirement as to dividend income and capital gains.

Accordingly there would be groups like, wanting no capital gains, wanting higher dividends and lower capital gains, wanting higher capital gains and lower dividends and so on.

When companies form their dividend policies, they may be having in mind, a particular group of stockholders whose needs of dividend/capital gains would be addressed. As long as the company maintains the same dividend policy, the group will stay with the company. If and when the company changes its dividend policy, the group of clients may change. This is called the elientele effect.

-The Residual Dividend Theory

Under this theory, dividends are paid out of residual earnings available after providing for the equity portion of the proposed capital budget. This will mean that the amount available for dividends would vary from year to year depending on the earnings and requirement for equity funding of capex.

This policy may not work well with any group of investors, except the ones who give more weightage to capital gains.

-The Signaling Effect of Dividends

Singalling theory holds that, when a firm increases dividends, the investors would consider it as a signal of bright future prospects and vice versa. Then it means that stable dividends would indicate steady profits.

-The Expectations Theory

When a firm aligns its dividend policies with the expectations of the stockholders at large, the price of the share will remain unchanged. If there is divergence between the two, the prices will get altered.