Question 4 (b)
The bird-in-hand argument
6 marks
- Time to write
- About 12 minutes
Question
Question 4 (b) · 6 marksExplain the "the bird in hand argument" in relation to dividend theories.
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- ExplainEach point stated, then explained in a line or two.
What the paper leaves open
"The the" is printed so and kept.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Meaning and source of the argument: Gordon; dividend relevance 1 mark 2 min
- 2 Risk aversion; current dividends more certain than capital gains 2 marks 3 min
- 3 Higher discount rate on retained earnings; effect on share price 2 marks 3 min
- 4 Conclusion and criticism 1 mark 2 min
- Check: every ask answered, key terms underlined 1 min
Easy marks
- Step 1 opens with the meaning: a one-line definition, the quickest mark in it.
Short on time? Trim steps 2 and 3 evenly rather than skip one: each is capped at its own marks. End with step 4 in a line or two.
Try it first. About 12 minutes for 6 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
The argument. The bird-in-hand argument is Myron Gordon's case that dividend policy is relevant to the value of a share. The name comes from the proverb "a bird in the hand is worth two in the bush": a dividend received now is certain, while the capital gain expected from retained earnings is uncertain.
1Sunita holds this year's dividend—money in her hand today.
Current dividendsInvestors put a premium on certain returns.
2Verma ji's payout sits inside a half-built project, and he worries.
Retained earningsUncertain future gains.
3At the counter, savers crowd the company that pays now over the one that promises later.
Bird in handInvestors are risk averse and value current dividends more than uncertain future gains.
- Investors are risk averse. They prefer a certain return to an uncertain one.
- Current dividends are less risky than future gains. Investors are surer of receiving a dividend now than of receiving a capital gain later, because the future is uncertain.
- So future gains are discounted at a higher rate. The extra risk of capital gains means investors apply a higher required rate of return to them than to current dividends.
- So the discount rate rises with retention. A firm that retains more and pays less is valued at a higher discount rate; investors pay a higher price for shares that pay current dividends and mark down shares of firms that postpone them.
Conclusion. Under this argument, a higher payout lowers the rate at which investors capitalise the firm's earnings and so raises the market price of the share, even if the return on investment equals the cost of capital. Dividend policy therefore affects the value of the firm.
Criticism. Modigliani and Miller reply that, given the firm's investment policy, a dividend paid now must be replaced by new capital, so the shareholder's total wealth is unchanged. The bird-in-hand view holds only if investors really do discount future gains more heavily, which MM regard as a fallacy.
Where the 6 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Meaning and source of the argument: Gordon; dividend relevance | 1 |
| 2 | Risk aversion; current dividends more certain than capital gains | 2 |
| 3 | Higher discount rate on retained earnings; effect on share price | 2 |
| 4 | Conclusion and criticism | 1 |
| Total | 6 |
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