Theories of Relevance Model

• Walter’s Model

Walter’s Model suggests that a firm’s dividend policy influences its valuation. It assumes that all earnings are either reinvested or distributed as dividends. Firms with high return on investment (ROI) should reinvest earnings rather than distribute them, as retained earnings generate higher returns than shareholders’ required rate. Conversely, firms with lower ROI should distribute more dividends since reinvestment yields lower returns. The model assumes constant ROI and cost of capital, which may not hold in real-life scenarios. Despite limitations, Walter’s Model emphasizes the direct relationship between dividend policy and firm valuation.

• Gordon’s Model

Gordon’s Model argues that investors prefer current dividends over future gains due to uncertainty, reinforcing the “Bird-in-the-Hand” theory. It suggests that retained earnings reinvested at lower-than-required returns harm shareholder value. Investors value companies that consistently pay dividends, as they reduce uncertainty. The model assumes a constant growth rate, no external financing, and a stable dividend payout ratio. While it highlights the impact of dividends on market valuation, it does not consider changing economic conditions or investor risk preferences, making it a somewhat restrictive model in dynamic financial markets.

• Lintner’s Model

Lintner’s Model explains that companies prefer stable and predictable dividends, adjusting gradually to changes in earnings. Firms follow a target payout ratio and adjust dividends cautiously to avoid sending negative signals to investors. According to this model, companies increase dividends only when they are confident about sustained profit growth. It assumes that firms are reluctant to cut dividends as it may create uncertainty among shareholders. Although it provides a realistic explanation of dividend behavior, the model may not fully apply to firms with volatile earnings or changing financial strategies.

• Signaling Theory

The Signaling Theory suggests that dividends convey important information about a company’s financial health. A higher dividend payout signals strong profitability and stability, attracting investors. Conversely, dividend reductions may indicate financial distress, leading to lower stock prices. This theory assumes that company insiders have better knowledge about future earnings than external investors, influencing dividend decisions. While dividends can serve as a credibility tool, they are not the sole indicators of financial performance. Some profitable firms reinvest earnings instead of paying dividends, limiting the universal applicability of this theory.

• Clientele Effect Theory

The Clientele Effect Theory posits that different investor groups prefer specific dividend policies based on their tax situations and income needs. Some investors, such as retirees, favor high-dividend stocks for stable income, while others prefer low-dividend or growth stocks for capital appreciation. Firms attract investors based on their dividend policies, and changing payout patterns may cause stock price fluctuations. However, this theory does not establish a direct link between dividend policy and firm valuation, as market conditions and investor behavior also play significant roles.

• Tax Preference Theory

The Tax Preference Theory states that investors prefer capital gains over dividends due to tax advantages. In many countries, capital gains taxes are lower than dividend taxes, making reinvestment more attractive. Investors may prefer companies that retain earnings and invest in growth rather than distributing dividends, as long-term appreciation offers tax benefits. This theory suggests that firms should design dividend policies considering tax implications, but it does not account for investor preferences driven by liquidity needs or market conditions.