Definition
The bird-in-hand theory of dividend policy were developed by Myron Gordon and John Lintner in response to the dividends irrelevance theory by Modigliani and Miller. The last one states that dividend policy has no impact on the value of a company or its capital structure. Conversely, Gordon and Lintner insist that dividend affect the stock’s price and investors’ behavior.
Assumptions
The bird-in-hand theory by Gordon and Lintner is based on following assumptions:
- The company is financed by equity only, i.e. debt finance is not used
- The only source of finance is retained earnings, any other sources of financing are not available
- The retention ratio is constant, i.e. there is constant growth rate of earnings
- The company’s cost of capital is constant and greater than growth rate
- There is no corporate taxes
Formula
Myron Gordon developed the model describing the relationship between the stock’s price and the dividend also known as the Gordon growth model or dividend discount model.
Where D0 is the per share amount of last dividend paid, g is constant growth rate, ke is investors’ required rate of return, D1 is expected dividend.
Breaking down bird-in-hand theory
The basic idea behind the bird-in-hand theory by Gordon and Linntner is that low dividend payout leads to increase in cost of capital. Therefore, the higher is dividend payout rate, the hire is stock’s price. This relationships are shown in the figure below.
The authors believed, that investors would prefer to get paid dividend now than capital gain in a while. In other words, dividends are more certain for investors than capital gain. They would not accept the proposal to decrease dividend payout in order to increase retained earnings and get bigger capital gains in the future. The longer is the period of time the greater is uncertainly, thus capital gains are more risky for investors than dividends.
The bird-in-hand theory claims that investors’ behavior is affected by dividend payout rate rather than capital gains. Also, the theory states that the higher is proportion of capital gain in total return, the higher is the required rate of return of investors, and therefore the cost of capital of company. In other words, Gordon and Lintner came to the conclusion that decrease of dividend by 1% requires increase in capital gains by more than 1%.
If investors are risk averse, they would prefer certain dividend than risky capital gains. Therefore, the required rate of return on capital gains is higher than on dividend for the same stock. That is why the present value of $1 of dividend is higher than $1 of capital gains expected to be received in the same moment in the future.
Criticism
The main critics of the bird-in-hand theory were Modigliani and Miller, who argued that the dividend policy has no impact on the cost of capital, and investors are only interested in total return, i.e. they are irrelevant to the proportion of capital gains and dividends.
The idea behind criticism of the bird-in-hand theory is that investors mostly reinvest dividend by purchasing stocks of the same or others companies. So, companies receive back the biggest portion of dividend payouts. Thus, the value of the company or cost of capital is irrelevant to the dividend policy and rather depends on its ability to generate earnings and business risk.
