Dividend or growth option? How compounding influences decision

Abhimanyu SofatAdviseSureGrowth option and dividend option are generally the two investment options an investor gets while investing in a mutual funds scheme. In growth option, an investor does not receive any dividends from the scheme. The investor in growth option can book profits only by selling the units of the mutual fund scheme. While in dividend option, an investor gets a dividend on his investments in a mutual fund scheme, the value of the NAV declines by the amount of dividend paid per unit. The investor should select an option after considering the following points:Effect of compounding -Compounding in layman term means getting returns on past returns. The impact of the power of compounding on a growth option scheme is more than a dividend option scheme because the former reinvest the returns (dividend from stocks or interest from debt securities) and does not pay dividends. The impact of the power of compounding can be understood by the below example.Let us assume that Mr. A and Mr. B had invested Rs. 1,00,000 each in growth option and dividend option respectively of XYZ equity mutual fund for 5 years. Both invested at same NAV of Rs. 100. Therefore, both got the same units i.e. 1000. Both the schemes grew at 15% per annum in 5 years and the dividend option scheme paid a dividend of Rs. 5 per unit every year.Source: AdviseSureAfter five years, the NAV of the growth option is doubled to Rs. 201 whereas dividend option’s NAV (adjusted for dividend) grew to Rs. 167.42 and unadjusted NAV was Rs. 192.42 (Rs. 167.42+Rs. 25). We can note that the NAV of the growth option is more than the unadjusted NAV of dividend option. This happened because of the effect of compounding, an investor does not get returns on dividend received. Therefore, in the long term, the returns from growth option will be higher than the dividend option (including the dividend paid). Hence, an investor should consider the effect of compounding before choosing growth option and dividend option. If an investor wants an additional income he has to compromise on the returns.Taxation-An investor should also consider the impact of taxation before choosing growth option and dividend option. Taxation on equity mutual funds and debt mutual funds is significantly different. There is no tax on dividend (if the dividend received is less than Rs. 10 lakh) and no long term capital gain tax on equity mutual funds. Whereas, in debt mutual funds, an AMC pays a dividend distribution tax (DDT) of ~28.84%, which is indirectly paid from investors investments. In addition, there is long term and short term capital gain taxes on debt mutual funds. Below table exhibits, the taxation on equity mutual funds and debt mutual funds for individual and HUF investors.Source: AdviseSureConclusion-The objective of the growth option scheme is to make wealth while dividend options aim to generate regular income. In growth option, a fund manager does not declare the dividend and allows the value of NAV to rise and generate good returns (the power of compounding). The dividend option is a good for those investors who needs an additional source of income, however, the dividends are not fixed and irregular.