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    Theories of Financial Management

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    ZehraAbdulAziz
    The Bird in Hand Theory postulates that investors prefer dividends to potential capital gains due to the uncertainty of the latter. It states that investors value the certainty of receiving dividend payments more than the possibility of higher capital gains. The theory was developed to counter the Dividend Irrelevance Theory, which argues that investors are indifferent to whether returns come from dividends or capital gains. Under the Bird in Hand Theory, stocks with higher dividends are more attractive to investors and command higher prices.

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    Theories of Financial Management

    Uploaded by

    ZehraAbdulAziz
    1K views5 pages
    The Bird in Hand Theory postulates that investors prefer dividends to potential capital gains due to the uncertainty of the latter. It states that investors value the certainty of receiving dividend payments more than the possibility of higher capital gains. The theory was developed to counter the Dividend Irrelevance Theory, which argues that investors are indifferent to whether returns come from dividends or capital gains. Under the Bird in Hand Theory, stocks with higher dividends are more attractive to investors and command higher prices.

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    5 theories of capital in financial management policy

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    The Bird in Hand Theory postulates that investors prefer dividends to potential capital gains due to the uncertainty of the latter. It states that investors value the certainty of receiving dividend payments more than the possibility of higher capital gains. The theory was developed to counter the Dividend Irrelevance Theory, which argues that investors are indifferent to whether returns come from dividends or capital gains. Under the Bird in Hand Theory, stocks with higher dividends are more attractive to investors and command higher prices.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    1K views5 pages

    Theories of Financial Management

    Uploaded by

    ZehraAbdulAziz
    The Bird in Hand Theory postulates that investors prefer dividends to potential capital gains due to the uncertainty of the latter. It states that investors value the certainty of receiving dividend payments more than the possibility of higher capital gains. The theory was developed to counter the Dividend Irrelevance Theory, which argues that investors are indifferent to whether returns come from dividends or capital gains. Under the Bird in Hand Theory, stocks with higher dividends are more attractive to investors and command higher prices.

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    © All Rights Reserved
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    of 5

    1) BIRD IN HAND THEORY:

    A theory that postulates that investors prefer dividends from a stock to potential capital gains
    because of the inherent uncertainty of the latter. Based on the adage that a bird in the hand is
    worth two in the bush, the bird-in-hand theory states that investors prefer the certainty of
    dividend payments to the possibility of substantially higher future capital gains.

    EXPLAINS BIRD IN HAND THEORY


    The theory was developed by Myron Gordon and John Lintner as a counterpoint to the
    Modigliani-Miller dividend irrelevance theory, which maintains that investors are indifferent to
    whether their returns from holding a stock arise from dividends or capital gains. Under the birdin-hand theory, stocks with high dividend payouts are sought by investors and consequently
    command a higher market price.

    Is A Bird In Hand Better Than Dividends In The Bush?


    Many dividend income investors are fond of citing the Bird In Hand theory when describing
    their investment philosophy.
    Based on the adage that a bird in the hand is worth two in the bush, the bird-in-hand theory
    states that investors prefer the certainty of cash proceeds that derive from dividend payments to
    the possibility of higher future cash proceeds that derive from capital appreciation via retained
    earnings.
    But this begs a question: Based on the logic of the bird in hand theory, why invest in stocks at
    all? Or even bonds for that matter?
    Why part with ones cash today (the bird in hand) to invest in a stock that promises to pay
    dividends in the future (the two birds in the bush)?
    Isnt cash in hand today better than dividends in the future?
    It is interesting to reflect upon this question.

    2) Dividend irrelevance theory


    A postulation that the dividend policy of a company should have minimal effect on
    the investment decisions made by an investor due to the fact that the payment or non-payment of
    a dividend will not necessarily impact the net return to the investor. The assumption is
    that dividends not paid are reinvested by the company to generate more profit, thus higher
    stock values.

    KEY POINTS

    Dividend irrelevance comes from Modigliani-Miller's capital irrelevance model, which works
    under specific market conditionsno taxes, no transaction costs, and no flotation
    costs. Investors and firms must have identical borrowing and lending rates and the same
    information on the firm's prospects.
    Firms that pay more dividends offer less stock price appreciation. However, the total return from
    both dividends and capital gains to stockholders should be the same, so stockholders would
    ultimately be indifferent between the two choices.
    If dividends are too small, a stockholder can simply choose to sell some portion of their stock for
    cash and vice versa.
    TERMS
    capital gains
    Profit that results from a disposition of a capital asset, such as stock, bond, or real estate due to
    arbitrage.
    dividend irrelevance
    Theory that a firm's dividend policy is not relevant because stockholders are ultimately
    indifferent between receiving returns from dividends or capital gain.
    flotation costs
    Costs paid by a firm for the issuance of new stocks or bonds.

    3) Tax preference theory:


    Tax preference theory is one of the major theories concerning dividend policy in an enterprise. It
    was first developed by Lichtenberger and Ramaswamy. This theory claims that investors prefer
    lower payout companies for tax reasons.
    Litzenberger and Ramaswamy based this theory on observation of American stock market. They
    presented three major reasons why investors might prefer lower payout comapnies.
    Firstly, unlike dividend, long-term capital gains allow the investor to deffer tax payment until
    they decide to sell the stock. Because of time value effects, tax paid immediately has a higher
    effective capital cost than the same tax paid in the future.

    Secondly, up until 1986 all dividend and only 40 percent of capital gains were taxed. At a
    taxation rate of 50%, this gives us a 50% tax rate on dividends and (0,4)(0,5) = 20% on longterm capital gains. Therefore, investors might want the companies to retain their earnings in
    order to avoid higher taxes. As of 1989 dividend and capital gains tax rates are equal but defferal
    issue still remains.
    Finally, if a stockholder dies, no capital gains tax is collected at all. Those who inherit the stocks
    can sell them on the death day at their base costs and avoid capital gains tax payment.

    4) Clientele effect:
    The clientele effect is the idea that the set of investors attracted to a particular kind
    of security will affect the price of the security when policies or circumstances change. For
    instance, some investors want a company that doesn't pay dividends but instead invests that
    money in growing the business, whereas other investors prefer a stock that pays a high dividend,
    and still others want one that balances payout and reinvestment. If a company changes
    its dividend policy substantially, it is said to be subject to a clientele effect as some of its
    investors (its established clientele) decide to sell the security due to the change. Although
    commonly used in reference to dividend or coupon (interest) rates, it can also be used in the
    context of leverage (debt levels), changes in line of business, taxes, and other aspects of the
    company.

    EXPLAINS CLIENTELE EFFECT:


    Consider a company that currently pays a high dividend and has attracted clientele whose
    investment goal is to obtain stock with a high dividend payout. If the company decides to
    decrease its dividend, these investors will sell their stock and move to another company that pays
    a higher dividend. As a result, the company's share price will decline.

    5) Stock Repurchase
    Stock repurchase may be viewed as an alternative to paying dividends in that it is another
    method of returning cash to investors. A stock repurchase occurs when a company asks
    stockholders to tender their shares for repurchase by the company. There are several reasons why
    a stock repurchase can increase value for stockholders. First, a repurchase can be used to
    restructure the company's capital structure without increasing the company's debt load.
    Additionally, rather than a company changing its dividend policy, it can offer value to its
    stockholders through stock repurchases, keeping in mind that capital gains taxes are lower than
    taxes on dividends.

    EXPLAINS 'SHARE REPURCHASE


    Because a share repurchase reduces the number of shares outstanding (i.e. supply), it increases
    earnings per share and tends to elevate the market value of the remaining shares. When a
    company does repurchase shares, it will usually say something along the lines of, "We find no
    better investment than our own company."

    Methods of Stock or share Re-Purchase


    Open-market
    Fixed price tender
    Dutch auction

    Types
    Selective buy-backs
    Other types

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