Dividend reinvestment vs growth option

The pros and cons of choosing the dividend option vis-à-vis growth option while investing in mutual funds were examined in detail in this column two weeks ago.

We discussed how the growth option scored over the dividend option. To recap, dividend money not utilised vegetates in the bank, thereby diluting the rate of return. And if it has to be reinvested in equity, then why take it out in the first place?

Besides, all funds pay dividends at their whim and not your fancy. This is why it makes sense to opt for the growth option and withdraw non-taxable long-term gains as dividend yourself.

This time, let’s see how the dividend reinvestment option stacks up against the growth option.

Dividend reinvestment
Again, let’s take the example of HDFC Equity Fund. As on March 31, the NAV of HDFC Equity Growth option was Rs 165.79, whereas that of the dividend option was Rs 38.25. Notice that there is no separate NAV declared for the dividend reinvestment option. Why is this?

The reason is simple. For all practical purposes, there is no difference between the dividend option and the dividend reinvestment option. In other words, the NAV of the dividend option of HDFC Equity would also apply to the dividend reinvestment option.
How does dividend reinvestment work?

Under the reinvestment option, instead of physically receiving the dividend in your bank, the mutual fund itself ploughs it back at source by buying additional units of the same scheme.

In fact, you could have done the same... after receiving the dividend, you could have written out a cheque to invest the dividend amount into the scheme. Since this is done at source, the only difference between the dividend option and the reinvestment option is the time saved in the latter. Of course, there is no entry load imposed, but that’s not the point.

Even when compared with the growth option, as the tax law stands today, in the absence of dividend distribution tax on equity-based funds and no long-term capital gains tax, there is absolutely no difference between the growth option and the dividend reinvestment option. Both will yield the same market value of your assets, as of today.

However, if the government were to reimpose the dividend distribution tax (currently only non-equity oriented funds suffer the 14.16% dividend distribution tax), then each time dividend is declared, 14.16% lesser would get reinvested. Over time, this difference would get significant as compared with the growth option.

On the other hand, if long-term capital gains tax is reintroduced. In this case, dividend reinvestment would prove superior to the growth option. This happens as each time the dividend is reinvested, the investor gets units. Eventually, when the investment is sold, the dividend represents the cost of the units and hence capital gain incidence is reduced.
Admittedly, all this can be a little confusing. therefore, let’s understand this with the help of an example.

Consider the following table. This is the investment in the growth option. The first investment is made on January 1, 2007, when 10,000 units are purchased @ Rs 10 for a total outlay of Rs 1,00,000. The scheme performs well and after one year, on January 1, 2008, the NAV of the scheme stands at Rs 13.

 Date Particulars No. of NAV Amount
   Units (Rs) (Rs)
 Jan 1, 2007 First investment  10,000 10 1,00,000
 Jan 1, 2008 Growth in value @30% 10,000 13 1,30,000

Now, if the investment is sold, the investor would earn a capital gain of Rs 30,000 and @10%, the tax would work out to Rs 3,000. (Remember, as of now, there is no capital gains tax, but we are assuming it would be imposed).

Now, let’s consider the same numbers under the dividend reinvestment option.
As on January 1, 2008, there is no difference between the dividend reinvestment and growth options. Then, the MF declares its first dividend of 20%, or Rs 2 per unit. The ex-dividend NAV stands at Rs 11 (Rs 13 - Rs 2). The investor will receive Rs 20,000 as dividend (10,000 units @ Rs 2 per unit). This Rs 20,000 gets reinvested at the ex-dividend NAV of Rs 11, thereby yielding 1,818.182 units (1818.182 x 11 = 20,000). The following table encapsulates this information.

 Date Particulars No of units NAV (Rs) Amount (Rs)
 Jan Value of  10,000 11 1,10,000
 1, 2008 first investment
 Jan Value of units  1,818.182 11  20,000
 1, 2008 received on account of
  dividend reinvested
 Total  11,181.182  1,30,000

Now, suppose all units are sold. The sale value of 11,818.182 units @ Rs 11 is Rs 1,30,000, the same as that of the growth option. However, there is a difference as far as cost is concerned.

The cost of the original units stands at Rs 1,00,000. However, the cost of the additional units on account of the dividend reinvested is Rs 20,000.

As the following table shows, the capital gain tax works out to Rs 1,000, significantly lower than the Rs 3,000 that we arrived at for the growth option. This example considers an investment of Rs 1,00,000 over one year. Higher outlays over longer periods of time will only amplify the  advantage of the dividend reinvestment option.

Capital gain No. of NAV Amount
 calculation units (Rs) (Rs)
Sale value 11,818.182 11 1,30,000 
(10,000+1,818.182) x 11
 Less: Cost
Original units 10,000 10 1,00,000
Units representing
dividend reinvested 1,818.182 11   20,000
    120,000
Long term capital gain   10,000
Tax thereon @10%   1,000
To sum up

Clearly, who wins the dividend reinvestment vs growth battle is decided only by the current tax policy. As of now, both are equal; there is no winner or loser. But, if tomorrow, distribution tax is imposed, growth will be the clear winner. If, on the other hand, long-term capital gains tax is imposed, Growth can’t touch dividend reinvestment.
But what about short-term gains? Readers would know that even equity funds suffer a 15% tax on redemptions before one year. Under specific circumstances, this factor may come into play.

Notice in the above example, actually, the units representing dividend reinvested are sold within a day. For ease of understanding and to keep things uncomplicated, I have used the long-term rate.

However, in practical life, the short-term tax rate would apply.
To put it differently, consider an investment in the dividend reinvestment option with a five-year horizon. Any dividend reinvested in the last year may be taxable as short-term capital gains if a period of 12 months doesn’t elapse between the sale date and the date of reinvestment. Take care of this pitfall.

sandeep.shanbhag@gmail.com