Question 4 (b)
'A bird in hand is better than two in the bush' and Gordon's theory
9 marks
- Time to write
- About 18 minutes
Question
Question 4 (b) · 9 marksIn the context of Gordon's Dividend Theory of valuation, discuss how relevant the proverb "A bird in hand is better than two in the bush" is.
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
- discussTie the answer to the quoted statement: say what it means first, and come back to it at the end.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Meaning of the proverb in the dividend context 2 marks 2 min
- 2 Gordon's reasoning: risk aversion, discount rate and retention 4 marks 8 min
- 3 Relevance and limits 3 marks 6 min
- Check: every ask answered, key terms underlined 1 min
Easy marks
- Meaning of the proverb in the dividend context (step 1, 2 marks): a clear definition and a line on what it covers. It opens the answer, so it takes a minute or two.
Short on time? Keep step 1 short. Trim steps 2 and 3 evenly rather than skip one: each is capped at its own marks.
Try it first. About 18 minutes for 9 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 proverb. A bird already in the hand is worth more than two still in the bush, because the two may never be caught. Applied to dividends, a dividend received now is certain, while the capital gain expected from earnings retained today 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.
Gordon's use of it. Myron Gordon's model holds that dividend policy is relevant to the value of a share:
- Investors are risk averse and put a premium on certain returns and a discount on uncertain ones.
- Current dividends are less risky than future gains, since the future is uncertain; investors are surer of receiving a dividend now than a capital gain later.
- So future gains are discounted at a higher rate. The extra risk of capital gains means investors require a higher return on them than on current dividends.
- So the discount rate rises with retention. Investors pay a higher price for shares that pay current dividends and mark down shares of firms that postpone them; the rate at which they discount the firm's earnings varies with its retention rate.
How relevant the proverb is. Within Gordon's theory it is the central argument: a higher payout lowers the rate at which investors capitalise the firm's earnings and so raises the share price, even when the return on investment equals the cost of capital. Its relevance is limited in practice where:
- the firm earns much more on retained earnings than shareholders could elsewhere (growth firms), so retention adds more value than a current dividend would;
- investors prefer capital gains, for example because of taxation; and
- under Modigliani and Miller's assumptions the dividend is offset by a lower share price, so total wealth is unchanged; MM call the bird-in-hand view a fallacy.
Where the 9 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Meaning of the proverb in the dividend context | 2 |
| 2 | Gordon's reasoning: risk aversion, discount rate and retention | 4 |
| 3 | Relevance and limits | 3 |
| Total | 9 |
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