Dividend Decisions^333
Tax Preference Theory: Litzenberger and Ramaswamy
If a firm retains its earnings then the share gains in value in the market which results in
capital gains for the shareholder. If the company pays out dividend the share value does
not increase but the shareholder gains cash. In case of getting dividends the shareholder
has effectively paid only 10% tax while in the case of capital gains he would be in the
20% tax bracket. This means that he would prefer to get dividends rather than get
capital gains but if the capital gains are disproportionate he would prefer capital gains
rather than dividends.
The tax preference theory holds that the value of the firm will be maximised by a low
dividend payout, because investors pay lower effective taxes on capital gains than on
dividends internationally. In India the situation is different and the shareholder would
prefer dividends rather than capital gains.
The above analysis suggests that there is a preference for current dividends - that, in
fact, there is a direct relationship between the dividend policy of a firm and market
value. The argument goes on the lines that investors are generally risk averse and
therefore attach less risk to current as opposed to future dividends or capital gains. In
the words of John E. Kirshmann "Of two stocks with identical earnings, records and
prospects but the one paying a larger dividend than the other, the former will undoubtedly
command a higher price merely because shareholder's prefer present to future values.
Myopic vision plays a part in the price-making process. Stockholders often act upon the
principle that a bird in hand is work two in the bush and for this reason are willing to pay
a premium for the stock with the higher dividend rate, just as they discount the one with
the lower dividend rate."
Benjamin Graham and David L. Todd, authors of the well-known security valuation
book 'Security Analysis' also say that "The typical investor would most certainly prefer
to have his dividend today and let tomorrow take care of itself. No instances are on
record in which the withholding of dividends for the sake of future profits has been
hailed with such enthusiasm as to advance the price of the stock. The direct opposite
has invariably been true. Given two companies in the same general position and with
the same earnings power, the one paying the larger dividend will always sell at the
higher prices."
These observations are supported by the share valuation models that have been
developed using the dividend payouts. Walter's model (which is actually an adaptation
of the Gordon's model) are given below.
Walter's Model
Walter's model is one of the earliest dividend models is adapted from the Gordon's
model for valuation of an equity share.