There are basically two options, which a firm has while utilizing its profits after tax. Firms can either plough back the earnings by retaining them or distribute the same to their shareholders. The first option suits those firms, which need funds to finance their long-term projects. However, such projects should have enough growth potential and sufficient profitability. On the other hand, the second option of declaring cash dividends form the profits after tax will lead to maximization of the shareholders wealth.
The returns to the shareholders either by way of the dividend receipts or capital gains are affected by the dividend policies of the firm. This is mainly due to the fact that the dividend policy decides the retention ratio and pay-out ratio (dividend as a percent of profits). Furthermore, the dividend policy of the firm gains importance especially due to unambiguous relation-ship that exists between the dividend policy and the equity returns. Thus, a firm’s decision should meet the investors’ expectations.
A few models, which studied this relationship and the dividend policies of firms, are given below:
- Traditional Position
- Walter Model
- Gordon Model
- Miller & Modigliani Position
- Rational Expectations Model
