Bird in Hand

Only available on StudyMode
  • Download(s) : 917
  • Published : January 1, 2011
Open Document
Text Preview
The Bird-In-The-Hand Theory

The essence of the bird-in-the-hand theory of dividend policy (advanced by John Litner in 1962 and Myron Gordon in 1963) is that shareholders are risk-averse and prefer to receive dividend payments rather than future capital gains. Shareholders consider dividend payments to be more certain that future capital gains – thus a “bird in the hand is worth more than two in the bush”.

Gorden contended that the payment of current dividends “resolves investor uncertainty”. Investors have a preference for a certain level of income now rather that the prospect of a higher, but less certain, income at some time in the future.

The key implication, as argued by Litner and Gordon, is that because of the less risky nature dividends, shareholders and investors will discount the firm’s dividend stream at a lower rate of return, “r”, thus increasing the value of the firm’s shares.

According to the constant growth dividend valuation (or Gordon’s growth) model, the value of an ordinary share, SV0 is given by:

SV0 = D1/(r-g)

Where the constant dividend growth rate is denoted by g, r is the investor’s required rate of return, and D1, represents the next dividend payments. Thus the lower r is in relation to the value of the dividend payment D1, the greater the share’s value. In the investor’s view, according to Linter and Gordon, r, the return from the dividend, is less risky than the future growth rate g.

M&M argued against this and referred to it as the bird-in-the-hand fallacy. In their irrelevancy model, M&M assume that the required rate of return or cost or capital, r, is independent of dividend policy. They maintain that a firm’s risk (which influences the investor’s required rate of return, r) is a function of its investment and financing decisions, not its dividend policy.

M&M contend that investors are indifferent between dividends...
tracking img