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. This states that dividend
policy has no impact on the value of a company or its capital structure.

In general term the bird in hand can can be understood as- The bird in hand is a theory that says
investors prefer dividends from stock investing to potential capital gains because of the inherent
uncertainty associated with capital gains. Based on the adage, "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.

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.

Stock Price = D0 × (1 + g)/ ke - g = D1/ ke - g

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.

Example of Bird in Hand theory

As a dividend-paying stock, Coca-Cola (KO) would be a stock that fits in with a bird-in-hand theory-
based investing strategy. According to Coca-Cola, the company began paying regular quarterly
dividends starting in the 1920s. Further, the company has increased these payments every year for
the last 56 years.

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.

Bird-in-hand theory of dividend policy

The investors under this theory prefer to get paid dividend now only 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.

Bird in Hand vs. Capital Gains Investing theory

An investor may gain an advantage in capital gains by conducting extensive company, market, and
macroeconomic research. However, ultimately, the performance of a stock hinges on a host of
factors that are out of the investor's control.

For this reason, capital gains investing represents the "two in the bush" side of the adage. Investors
chase capital gains because there is a possibility that those gains may be large, but it is equally
possible that capital gains may be evevn nonexistent.

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.

Conclusion: under this theory share holder consider dividend payment to be more certain than that
of future capital gains;thus it is said as “A bird in hand is more preferable than two birds in the
bush”.

2. Calculation of cumulative frequency after tax

EBDT 6000

Less: depriciation 2000 (20000*10%)

EBT 4000

Less:taxes @30% 1200

EAT 2800

ADD: DDEPRICIATION 2000

CFAT 4800

YEAR CASH INFLOWS ( IN rs.) DF @10% PVF

1 TO 10 4800 6.145 29496

PRESENT VALUE TOTAL

LESS: CASH OUTFLOWS 29496

20000

TOTAL 9496

Since the npv is greater than 0 the value of investment can be accepted

Pv per rupee investment = present value of total inflow / total investment

= 29496 /20000

= 1.47

4.cash req. 20 lacs

(Lot size)

Option1 option2 option 3 option4 option5

100,000 200,000 400,000 500,000 10,00,000

(No of lots required)

20 10 05 04 02

(Transaction Cost @2000) + Oppp. cost@20% of Lot size

40000+20000=60000

20000+40000=6000

10000+80000=90000

8000+10000=1,08,000

4000+200000=2,04,000
3.cost of equity = DPS+GRD/CMV

DPS=dividend per share for next year

CMV= current market value of stock

GRD =growth rate of dividend

DPS=rs 100

CMV=10000; GRD=10

COE=100+10/10,000

COE=10.001%