Bird-in-the-hand theory
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Bird-in-the-hand Theory is one of the major theories concerning dividend policy in an enterprise. This theory was developed by Myron Gordon (1963) and John Lintner (1964) as a response to Modigliani and Miller's dividend irrelevance theory.
Gordon and Lintner claimed that Modigliani and Miller made a mistake assuming lack of impact of dividend policy on firm's cost of capital. They argued that lower payouts result in higher costs of capital. They suggested that investors prefer dividend as it is more certain than capital gains that might or might not appear if they let the firm retain its earnings. The authors indicated that the higher capital gains/dividend ratio is, the larger total return is required by investors due to increased risk. In other words, Gordon and Lintner claimed that one percent drop in dividend payout has to be offset by more than one percent of additional growth.
Investors are risk averse and believe that incomes from dividends are certain rather than incomes from future capital gains, therefore they predict future capital gains to be risky propositions. They discount the future capital gains at a higher rate than the firm's earnings, thereby evaluating a higher value of the share.
Bird in the hand theory assumptions
- corporation has only equity (it has no debt in its capital structure),
- external financing is unavailable, so company can finance expansion and development only by retaining its earnings,
- returns are constant, diminishing marginal efficiency of investment are not taken into account,
- corporation has constant cost of capital.
Criticism of Gordon and Lintner model
Bird-in-the-hand theory was criticised by Modigliani and Miller who claimed that dividend policy does not affect the firm's cost of capital and that investors are totally indifferent if they receive more dividend or capital gains. They called Gordon and Lintner's theory a bird-in-the-hand fallacy indicating that most investors will reinvest the dividend in the similar or even the same company and that company's riskiness is only affected by its cash-flows from operating assets.
Examples of Bird-in-the-hand theory
- A company that has a large amount of cash on hand, but is not sure how to best use it, may decide to implement the Bird-in-the-hand theory and pay out a dividend to its shareholders. This will provide them with an immediate benefit as opposed to investing the funds, which could take time to provide a return.
- A company that wants to reward its shareholders may also use the Bird-in-the-hand theory and pay out a dividend. This will provide the shareholders with a direct reward for their investment rather than waiting for the potential of future profits.
- A company that is facing financial difficulties may also use the Bird-in-the-hand theory and pay out a dividend. This will provide the shareholders with a return on their investment, even if the company does not make a profit or is unable to pay dividends in the future.
Advantages of Bird-in-the-hand theory
- The Bird-in-the-hand Theory suggests that corporations should pay out dividends to their shareholders in order to maximize their stock price.
- This theory believes that dividend payments are a signal of a company's financial health, which could increase the confidence of investors and encourage them to purchase the stock.
- Dividend payments also provide shareholders with a steady source of income, which could make them more likely to invest in the company in the long-term.
- Furthermore, dividend payments can help to reduce the agency costs between shareholders and managers, as they provide shareholders with an incentive to monitor the activities of the managers.
- Lastly, the Bird-in-the-hand Theory acknowledges that dividend payments are a form of liquidity and can help to reduce the cost of capital for the company.
Limitations of Bird-in-the-hand theory
- One limitation of the Bird-in-the-hand Theory is that it assumes a stable dividend policy with no changes to the dividend payments over time. This fails to take into account the fact that companies often change their dividend policy in response to changing market conditions.
- Another limitation of the Bird-in-the-hand Theory is that it assumes that investors prefer cash dividends to stock dividends. However, investors may prefer stock dividends for tax or other reasons, making the Bird-in-the-hand Theory less applicable.
- The Bird-in-the-hand Theory also assumes that investors are risk-averse and prefer a certain amount of cash dividend payments over uncertain stock prices. However, investors may be risk-tolerant and prefer stock prices with the potential for higher returns over cash dividend payments.
- Finally, the Bird-in-the-hand Theory fails to take into account the effects of inflation on the value of dividends. Over time, the purchasing power of cash dividend payments will decrease due to inflation, making the Bird-in-the-hand Theory less applicable.
Other approaches related to Bird-in-the-hand theory include the following:
- The Walter Model or Walter’s Irrelevance Theory (1962) states that dividend policy has no effect on the value of a firm and is therefore irrelevant.
- The Lintner Model (1956) proposed that dividends are determined by the target payout ratio, the average payout ratio of the firm’s peers, and the current financial performance of the company.
- The Residual Model (1957) suggests that dividends are determined by the amount of retained earnings and the amount of cash available for dividends after current investments.
- The Bird-in-the-bush Theory (1966) argues that investors prefer dividends to capital gains as dividends are taxed at a lower rate.
In summary, other approaches related to Bird-in-the-hand Theory include the Walter Model, the Lintner Model, the Residual Model, and the Bird-in-the-bush Theory. These theories argue for different aspects of dividend policy, but all seek to explain how firms can maximize the value of their dividends.
References
- Anderson, G. J. (1983). The internal financing decisions of the industrial and commercial sector: a reappraisal of the Lintner model of dividend disbursements. Economica, 50(199), 235-248.
- Bhattacharya, S. (Spring, 1979), Imperfect Information, Dividend Policy, and "The Bird in the Hand" Fallacy, The Bell Journal of Economics, Vol. 10, No. 1, p. 259-270.
- Deeptee, P. R., Roshan, B. (March, 2009), Signalling Power of Dividend on Firms’ Future Profits. A Literature Review, EvergreenEnergy – International Interdisciplinary Journal, New York.
- Easterbrook, F. H. (1984). Two agency-cost explanations of dividends. The American Economic Review, 74(4), 650-659.
- Gordon, M. J. (1960). Security and a financial theory of investment. The Quarterly Journal of Economics, 472-492.
- Lintner, J. (1962). Dividends, earnings, leverage, stock prices and the supply of capital to corporations. The review of Economics and Statistics, 243-269.
- Miller, M. H., & Modigliani, F. (1961). Dividend policy, growth, and the valuation of shares. The Journal of Business, 34(4), 411-433.
- Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment, The American economic review, 48(3), 261-297.
- Modigliani, F., & Miller, M. H. (1965). The cost of capital, corporation finance, and the theory of investment: Reply. The American Economic Review, 55(3), 524-527.
- Dividend policy @ Wikipedia.
Author: Krzysztof Wozniak
