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.
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- Dividend policy @ Wikipedia.
Author: Krzysztof Wozniak