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Bird in hand is a theory that postulates investors prefer dividends from a stock to potential capital gains because of the inherent uncertainty of the latter. Based on the adage a bird in the hand is worth two in the bush, the bird-in-hand theory states investors prefer the certainty of dividend payments to the possibility of substantially higher future capital gains.BREAKING DOWN 'Bird In Hand'
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 bird-in-hand theory, stocks with high dividend payouts are sought by investors and consequently command a higher market price .Dividend vs. Capital Gains Investing
Investing for capital gains is predicated largely on conjecture. An investor may gain an advantage in capital gains by conducting extensive company, market and macroeconomic research, but ultimately, the performance of a stock hinges on a host of factors completely out of the investor's control.
For this reason, capital gains investing represents the "two in the bush" side of the old adage. Investors chase capital gains because of the possibility of those gains being large and making the investor rich, but the possibility is just as real that capital gains are nonexistent or, worse, negative.
Broad stock market indices such as the Dow Jones Industrial Average (DJIA) and the Standard & Poor's (S&P) 500 have averaged 9 to 10% in annual returns over the long term. It is very difficult to find dividends that high. Even stocks in notoriously high-dividend industries such as utilities and telecommunications tend to top out at 4 to 5%. However, if a company has been paying a dividend yield of, say, 5% for many years, receiving that return in a given year is much more of a sure thing than earning 9 or 10% in capital gains.
During years such as 2001 and 2008, the broad stock market indices posted big losses, despite trending upward over the long term. In years such as these, dividend income is more reliable and secure, hence being dubbed the "bird in hand."Disadvantages of the Bird in Hand
Legendary investor Warren Buffett once opined that in investing, what is comfortable is rarely profitable. Dividend investing at 4 to 5% per year provides near-guaranteed returns and security, but over the long term, the pure dividend investor has earned far less money than the pure capital gains investor. Moreover, during some years, such as the late 1970s, dividend income, while secure and comfortable, has been insufficient even to keep pace with inflation.
Published: 23rd March, 2015 Last Edited: 23rd March, 2015
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The aim sought by the proponents of the irrelevance proposition hypothesis is that the cash dividends policy has no effect on the company value or the capital cost. Consequently, the cash dividends policy will not affect the returns on capital required. Many other theorists (Lintner 1962; Gordon 1963) see that the returns on capital required rise when the cash dividends ratio decreases because investors are less sure of their capital gains resulting than the return earnings and rising stock prices from obtaining these cash dividend. Those writers (Lintner 1962; Gordon 1963) think that investors evaluate the dollar, which they receive from cash dividends, more than the dollar they would receive from capital gains. The reason is that the dollar received from cash dividends today is less risky than the future dollar received from capital gains. It is known that investors evaluate share prices through a predictable future cash flow per share and then discount it in a rate reflecting the risks. This discount rate has a positive relation with risks, therefore the discount rate which is used to determine share price with future capital gains will be greater. As a result, the company's share price which has a low cash dividend and high return earnings for future capital gains will be less than the share price which has high cash dividends. Therefore, the share price will drop when return earnings increase for future capital gains.
A preliminary reading of the "bird in the hand theory" shows that it seems acceptable on the basis that shares with high cash dividend are less risky. With the stability of other factors affecting the share price, the less risky stocks are more expensive. The question to be raised here is: Has the dividends policy affected the company's risk level? Or do the risks affect the dividends policy?
Among the reasons proposed by Rozeff (1982) in his study to explain how the companies with high-risk distribute low cash dividends is the fact that the managers are aware that these companies profits have uncertainty risks. So the managers prefer low cash dividends because they don't want to find themselves forced in the coming years, with profits of many uncertainty risks to reduce cash dividends rate which is familiar for shareholders because they are evaluate the consistency in cash dividend level more than cash dividend its self (Gombola and Feng-Ving 1993). This means that the high risk for the company has led to a reduction in the cash dividends rate distributed. Also, the decrease in cash dividends is a result of the company high risks and not vice versa.
To sum up, the "bird in hand theory" proposes that capital gains are more risky than cash dividends and that investors prefer companies that distribute cash dividends more than the companies that hold the profits to convert them into capital gains. Because of their preferences, the investors are paying higher prices for the company's shares with cash dividends, compared with the company holds their profits when other factors are fixed. On other words, this theory indicates that if the company wants to maximize their share price, then they should pay a high dividend ratio (Baker and Powell 1999).
However, (M&M, 1961) assumption does not accept this concept and says it is "Bird in-the-Hand Fallacy". (Bhatacharya, 1979) says that future cash flow risk for any project determines its risk; therefore, any incremental in cash dividend now will decrease shares price after cash dividend and the decrease future cash flow risk by increase cash dividend today will not increase companies value.
An accurate reading of the "bird in the hand" theory, as stated by Gordon (1959), shows that this theory tends to consider the investment policy and not the cash dividends policy as it seems from the initial reading. The result that can be drawn from this theory is that the companies that distribute low cash dividends are often high-risk investment companies. Due to high investment risks, investors would discount future cash flows of low cash dividends - companies with high risks - with a larger discount rate when they evaluate these companies' shares prices. As such, they find themselves willing to pay a less price for the shares of these companies with the stability of other factors. In other words, the discount rate used to determine these companies' shares price depends solely on the risk level, regardless of the dividends policy followed by these companies. The cash dividends policy, on its part, is only the inevitable result of the company's risk level, and not the reason for it.2-3-2-3 Tax Effect Theory
This theory assumes in brief that if there is no tax for capital gains, or that the capital gains tax is less than cash dividend tax, the investors prefer companies that do not distribute cash dividends, and that tend to retain profits in the form of undistributed profits. Whenever the cash dividends percentage decreases at the expense of undistributed profits, owners' wealth will maximize with other factors constant. Therefore, the investors will ask companies that distribute high cash dividends for a greater return, in comparison with the returns of companies that have no cash dividends to cover the taxes they will pay for cash dividends (Brennan 1970; Litzenberger and Ramaswamy 1982). In other words, the investors would accept returns prior to taxes which is lower in case of companies that provide capital gains instead of the cash dividends. The investors, on the other hand, would pay a higher price for the company's shares that provide returns in the form of capital gains instead of distributing them as cash dividends while other factors affecting the share price are fixed. Here comes the role of dividends policy and its impact on the company's value and shareholders wealth. Through the retention of profits and converting them into capital gains, the company's value and the shareholders' wealth could well be affected positively.
We can find the Tax Effect Theory by examining the bond market (Brigham, L. et al. 1999). When a comparison is made between the bonds returns issued by municipalities and the bonds returns issued by the Federal Government and corporate bond yields of the same risks in USA, it is noticed that the Federal Government and corporate bonds returns are more than the municipality bonds. The reason is that the federal and companies bonds are taxable while the municipal bonds are not for those who meet the residency requirements in the vicinity of the municipal bonds exporter, which means that the investor demands greater returns on bonds that are taxable to cover the value of the taxes to be paid (Brigham, L. et al. 1999).
Tax effect on dividends policy differs depending on the tax system. In USA for example, cash dividends are subjected to a double tax. After the company pays taxes on its profits, the cash dividends received by shareholders are considered to be part of the taxable income at the individual level (Brigham, L. et al. 1999). In Other countries such as Australia (Brealey and Myers 2003), the company profits are subject to taxation at a specified rate decided by law. After the distribution of cash dividends to shareholders, these dividends are subject to the personal tax rate, applicable to every investor taking into account the taxes paid by the company's, so that these dividends are not subject to double taxation. If the company's tax rate is 30% while the personal taxes rate for shareholders is 38%, then the shareholders will pay 8% for their cash dividends in addition to the company's payment, while the shareholders will get tax refunds of 5% if the his personal tax rate is 25%. This is known as An Imputation Tax System.
In UK also, the tax system aim to eliminate some of the tax consequences of dividend policy by operate an Imputation Tax System (Broyles 2003). The companies pay a tax (at the basic rate) on the grossed up to dividend to the Inland Revenue (higher rate taxpayers pay additional tax on the dividend). The government treats this withholding tax as part of the companies' corporation tax, however. Therefore, from the perspective of the basic rate taxpayer, there are only two taxes on corporate income, corporation tax and capital gains tax.
The Tax Effect Theory supporters - in the countries where the taxes on cash dividends are greater than capital gains tax rate - believe that the cash dividends cause damage to the investor who receives them because as it is subject to a tax rate higher than the taxes applicable to the other alternative for the cash dividends. Therefore, the cash dividends lead to a decrease the company's value and reduce the owner wealth (Brennan 1970). As a result, the shareholders would be in a better position if the company had their profits detained and transferred to the capital gains, rather repurchase its shares.
We can determine the positive or negative impact of cash dividends on shareholders' wealth because of the tax difference between cash dividends and capital gains as follows (Damodaran 1997):
If the decline in the share price after the share has become dividends free is equal to the value of the cash dividends, the investor they will not be affected whether the return takes the form of cash dividends or capital gains and there is no tax effect on the shareholders' wealth.
If the decline in the share price after the share has become without dividends is less than the cash dividends, then the tax rate on cash dividend will be greater than the tax rate on capital gains, and the investor will be in the best position if the return takes the form of capital gains.
If the decline in the share price after the share has become without dividends is greater than cash dividends, then the tax rate on capital gains will be greater than taxes on cash dividends, and the investor will be in his best position if the return takes the form of cash dividends.
This is related to taxes on cash dividends and capital gains, but what would be the case if the company tended to detain profits and reinvested them instead of distributing them to shareholders. Would this lead to maximizing shareholders' wealth?
The shareholders' maximized wealth through the dividends policy of the companies that have a surplus of funds depends largely on the tax rate on personal profits level of individual shareholders, and the taxes rate imposed on the company's profits. It is presumed here that both the company and shareholders can reinvest the profits in the same return rate. Yet, if the personal tax rate for shareholders is less than the company's tax rate, the shareholders will be in a better position if the company seeks to distribute cash dividends, and shareholders tend to reinvest their dividends by themselves. But if the company's tax rate is less than the shareholders' tax rate, then the shareholders would be in a better position if the company detains the profits, reinvests them, and then distributes the dividends with the returns to shareholders, assuming that risks and returns on investment are equal in both cases.
The important question here, is the above concept means that the investors in high tax bracket will not buy the shares with cash dividend? Despite of the tax effect, there are many researchers (Miller and Scholes 1978; Auerbach 1979; Feldstein and Green 1983) have found that the investors in high tax brackets still buy shares for the companies pay cash dividend.
Tax effect theory considers, in the countries where taxes rate on cash dividends is more than taxes rate on capital gains resulting from the purchase and sale of shares, the cash dividend to be as damages inflicted on shareholders wealth in case there is another alternative known as capital gains. In their study, Miller and Scholes (1978) found that we could avoid the negative impact of cash dividends tax through two steps: first, the investor will invest in stocks with high cash dividends by borrowing so that the amount of cash dividends is equal to the amount of loan interest. Since interests are considered to be a reduction in the income for tax purposes, while cash dividends are exposed to taxes, the impact of the tax benefits would cancel the impact of cash dividends. As a result, the investor will not pay taxes for cash dividends, but the portfolio risk as a result will be high because of borrowing. Here comes the second step which is represented in investing a sum of fund equal to the loan value in tax-deferred account to reduce borrowing risks. The result, however, is the investor will not suffer from the negative impact of taxes even though he had already invested in high-cash dividends shares.
The researcher believes that Miller and Scholes (1978) didn't give treatment to the negative impact of the cash dividend on the wealth of shareholders since the capital gains alternative is available. As far as offer solution for own share with cash dividend without pay tax for theses cash dividend regardless to the final net cash flow. The final net cash flow which for the investor using Miller and Scholes vision will be equal to what he get from Tax-deferred account because the share return will go by pay the interest. Besides that, it is known that the returns on these investments less than the returns on share investment, therefore, the researcher belives that the investor would be better if he invested his money in stocks distributed cash dividends with tax effect than follows the style of Miller and Scholes .
Also, the tax effect theory supporters believe that the investors who will purchase company shares without cash dividends or depressed cash dividends to reduce high tax impact on cash dividends. In case the investor's desire to obtain continuous cash dividends covers his requirements, he can sell part of his shares equal to the value of cash dividends he will have got if the company tended to distribute the cash dividends avoiding throughout high taxes. This is known as homemade dividends.
The researcher believes that such a proposition is practically not correct, as it does not maximize the shareholders' wealth due to the fact that the continuing and repeated sales processes are expensive due to transaction costs associated with them. If the capital gains tax is added to these costs, we might come to the conclusion that the cash dividends is the cheapest way to get the necessary cash for the shareholder to meet his/her needs instead of the capital gains.
In addition, the researcher is not in favor of the view that the cash dividends contribute to damage the shareholders' wealth as the tax rate on cash dividends is higher than the tax rate on capital gains. This is owing to the fact that there are shareholders who buy shares of companies that make cash dividends. Connected with this, the researcher believes that there should be greater benefits than damages that stimulate investors to buy those shares, the most important of which is represented in the low risks of cash dividends -sometimes the risks become nil.2-3-2-4 Clientele Effect Theory
In their study, Black and Scholes (1974) found that each investor has his own implicit calculations regarding preference between high cash dividends benefits or their detention, under the circumstances he is experiencing, like the tax category he is exposed to. As a result, some investors would prefer companies with high cash dividends whereas others prefer companies with low cash dividends or without any cash dividends and detention for investment. In other words, investors will invest only in companies which have dividends policy consistent with their special desires, requirements and conditions. This is known as the Clientele Effect.
In a study which analyzed 914 investment portfolios (Damodaran 1997), it has been found that older investors and lower-income investors tend to acquire the company's shares with high cash dividends more than younger investors with more income. The elderly and lower-income investors are exposed to low tax category or they enjoy tax exemptions. To be sure, the cash dividends represent one of the most important incomes for them to cover their consumer requirements or they want to enjoy their wealth before they die; therefore, they tend to invest in high cash dividends companies, while the younger investors and more affluent ones who are subject to high tax category. In their attempts to avoid paying taxes on these dividends, they tend to invest in companies with low or without cash dividends if we know that young people have not yet reached the retirement age. Therefore, the cash dividends often do not constitute a source of consumer needs; in addition, they are more susceptible to endure the uncertainty risks of capital gains and their aspirations and long-term projects such as educating children and owning housing, etc.
Through proper understanding of the Clientele Effect theory as stated by Black and Scholes (1974), which stipulates that investors will invest their money in companies which follow cash dividends policy consistent with their wishes with no effect on the company's value, the companies that do not distribute cash dividends or distribute only low cash dividends, would not face a negative effect as to their shares because they attract investors who show a desire for that. Similarly, the companies that distribute high cash dividends should not suffer reduced shares value in the market should not be reduced due to tax negative impact because they attract investors who show a desire for high cash dividends.
The question to be raised here is: Is the impact of the Clientele Effect so strong as to cancel the cash dividends effect on the company's value? If the influence is strong enough to the extent that it cancels the relationship between cash dividends policy and the company's value, then the share return must not be affected by cash dividend policy.
Black and Scholes attempted to answer this question. They created 25 investment portfolios from companies listed in New York index and then classified the companies as per cash dividends policy followed into five groups. Then they divided each group into five categories according to risk (beta coefficient). The study covered a period of 35 years (from 1931 to 1966) (Black and Scholes 1974). Examining the investment portfolios returns compared with the cash dividends (cash dividends distribution policy in place), they did not find any statistically significant relationship between the cash dividends and the total portfolio return. In another study carried out by both Litzenberger and Ramaswamy (1979) to determine whether the total portfolio return in the Ex-dividend month of distribution has any relationships with cash dividends, they has been found that there is a strong direct correlation between the portfolio total return and cash dividends. This supports the theory that investors do not prefer cash dividends because of the negative impact of taxes on these dividends. They also found that the impact of the tax rate difference on cash dividends and capital gains reaches up to 23%. This means that investors will be paying less for the company shares value that distribute cash dividends or demanding greater returns on these shares to offset the negative impact of the different tax rate between cash dividends and capital gains, which means that the clients effect was not strong enough to force cancellation of the cash dividends policy effect on the company's value.
Miller and Scholes study (1982) accused Litzenberger and Ramaswamy's study of being distorted in that it was affected by cash dividends increase or lack of information. They excluded all companies that have announced their profits and distributed them in the same month in order to mitigate the impact of the dividends declaration. They came to the conclusion that the portfolio total revenue is in direct proportion with the cash dividends, but that the impact of the difference between the tax percentage on cash dividends and capital gains is not 23%, but rather only 4%. This influence in statistical significance does not differ from the impact of zero, which means there is no effect regarding the difference of tax rate on cash dividends and capital gains. However, the direct relation between the total portfolio returns and cash dividends could reflect the share price increase due to the unexpected increase in cash dividends and not the negative impact of the taxes. This means that the clientele effect is force strong enough to neutralize the impact of the cash dividends policy on the company's value.
The clientele effect theory involves two important concepts:
The company tends to choose clients (investors) through a cash dividends policy consistent with their aspirations. Therefore, investors would not punish the company, or work to reduce the company's shares price because of that policy as it harmonizes with their wishes. On that basis, the investment process is performed in that company
Since the company chooses its customers through the cash dividends policy. Also, the company can transform from a dividends policy to another without the impact of that change on the company's value (if the change in the dividends rate does not result from future financial difficulties). If the company reduces cash dividends rate, the investors who want a higher dividend rate will sell their shares and turn to another company. On the other hand, investors who prefer low dividends percentage will take their place.
This implied meaning of the Clientele Effect theory might be acceptable in theory. From the practical perspective, it might encounter some problems. The company's ability to choose clients without affecting the company's value is presumably based on the assumption that the market is deep and the company will find enough clients to cover their shares offers to keep the share price balanced. But what would happen if the percentage of companies that distribute high cash dividends constitute a 10% of the total offer shares, while companies that distribute low cash dividends is 90% of market size? Likewise, what could be the case if the percentage of investors who prefer high cash dividend is 70% of the total volume of investors, while the percentage of investors who prefer low cash dividend is 30% of the total volume of demand for equities? The answer is that the shares of companies that offer low dividends will be greater than the demand for these shares. This will naturally lead the price of these shares to decline to become more acceptable to investor. To be sure, the market will be balanced at that low price. Offers of shares distributed by companies with high cash dividends are less than their demand. The result is that the shares prices of these companies would rise to become less attractive from the investors' points of view and therefore the demand would decrease while the market would be balanced at that relatively high price. On the other hand, the company's ability to change the cash dividends policy without affecting the company's value and shareholders' wealth is also based on the assumption of the market's depth and efficiency. If the company changes the cash dividends policy, all or most investors will abandon the company's shares and tend to invest in shares of other companies that have cash dividends policies that consist with their desires and needs. The resulting process of large selling quantities is liable to increase the supply of these stocks significantly, leading to a drop in prices. If the market is deep, the decline will be only temporary, but if the market is shallow, where there is no sufficient number of investors who favor that new policy, then the decline in provisional equity prices of these companies may turn into a permanent decline, which would be reflected negatively on the company's value and shareholders' wealth. It may also expose them to the transaction costs when they buy and sell, in addition to the possibility of being subjected to capital gains taxes, which will be reflected negatively on shareholders' wealth.2-3-2-5 Signaling Effect Theory
As per this theory, the managers use the change in cash dividends distributed rates as a means to deliver information to investors about the company (Denis, Denis et al. 1994). This theory supporters believe that the increase in the cash dividends rate is deemed an effective means of delivering information to investors because competitors cannot use the company's tradition of the same means unless they have actually the same capacity to achieve future profit (see:Charest 1978; Asquith and Mullins Jr 1983; Kalay and Loewenstein 1986; Impson 1997; Doron and Ziv 2001).
When M&M (Merton and Modigliani 1961) introduced their hypothesis about the Irrelevance Proposition on the company's cash dividends policy of the company's market value, one of the assumptions has been that all investors have the same information and ability for understanding and analyzing available information. Therefore, they have the same future outlooks concerning the company. Also, the investors and managers have the same information and therefore they have the same future expectations for the company. In practical life, however, and because of what is known as asymmetric information (Dewenter and Warther 1998), investors have different expectations and information with respect to the company's future profits and risks. Furthermore, by virtue of their position within the company and the nature of their work and career interests and duties, the managers have better and more accurate information and expectations than external investors regarding the company's profits and performance. As the managers have information that may not be available to external investors, they can use the change in the cash distributed dividends rate as a way to deliver such information to investors to reduce the gap information between managers and investors with the aim of creating a greater demand for the company's shares, and then influencing the company's market value and shareholders' wealth.
Among the findings of Aharony and Swary's study (1980), the company's shares prices usually rise when the companies suddenly or unexpectedly tend to increase cash dividends. These prices are reduced when the company suddenly or unexpectedly reduces the cash dividends. Also Kown in his study (1981) came to the same results, adding that companies usually do not increase their cash dividends unless they expect an increase in the future profits on an ongoing basis and sufficient to cover the cash dividends increase and continue the same good level in the coming years without being compelled to reduce the cash dividends rate in the coming years. Ross and others (Ross, Jaffe et al. 1999) find that it is not expected that the companies that do not expect future profits to increase the cash dividends rate because the costs of this process are too high and have future negative effects that exceed the temporary positive effects expected from increase cash dividends for companies that do not expect future additional profits. As such, the future increase in the cash dividends is a positive indicator of the company's future performance. If the company increases the cash dividends, it will generate positive conclusions for investors about the company's future profits, leading to an increasing demand on the part of investors on these shares, which leads to a rise in their prices.
The supporters of the Signaling Effect theory believe that cash dividends is the ideal means to deliver specific information about the company to investors. However, many others see that cash dividends not the best way to communicate such information to investors. Born and Rimbey (1993) find that change in the cash dividends rate may give incomprehensible and misleading signals unless the market finds itself able to distinguish between growing companies that tend to retain their profits for investment and growth, and also companies that have exhausted all available investment opportunities available to them and don't have any such opportunities to invest funds and therefore seek to distribute their profits. When Florida Power & light company announced reducing first quarter dividend in 1994 by 32%, the market's reaction was a decline in shares prices by 20%. After it became clear that the reduction in cash dividends was not a result of the expected future financial difficulties, but was due to a strategic decision to improve the company's financial flexibility and growth opportunities, the share prices have witnessed a gradual rise. This example gives evidence that the cash dividends distributions sometimes may give a misleading indicator. Sending a positive signal, the increase in the cash dividends may involve some negative repercussions on the company if these are understood in a certain way. For example, if the company is growing and accomplishing noticeable improvement and high returns on investment, and at the same time it did not distribute any dividends during the previous period, the dividends distribution might be looked at by shareholders as a negative indicator. This change can be explained by the company's inability to find new investment opportunities or that the investment opportunities available to the company are no longer profitable as is the case before. Such an understanding of cash dividends increase would lead to a decline in the company's shares value.
Through proper understanding of the Signaling Effect theory, it is clear that the positive or negative expectation of investors on the company's future performance leads to an increase or decline in the company's shares price, and not an increase or decrease in the cash dividends rate. The change in the ratio is only a means through which investors can expect the company's future performance. The M&M study (1961) asserts that the investors' reaction to change in cash dividends policy does not necessarily mean that investors prefer cash dividends to capital gains as they are proof of the importance of the cash dividends policy content of information.
The empirical studies examining the information content of dividends policy, or the Signaling Effect theory, have, in many cases, projected inconsistent results as is the case with all theories of dividends policy. But all studies agree on the existence of an information content for the dividends policy leading to an increase in stock prices if the company tends to increase the cash dividends ratio unexpectedly reduces the price of shares in case the company seeks to reduce the cash dividends and studies differ on the reasons for the increase or decrease in stock prices between the information content reason alone or the information content with the investors' wish for cash dividends and their preference for companies that distribute cash dividends.
At this point, a basic question is raised here: Does the change in the distributed cash dividends rate represent the most efficient means available for the company to deliver information to investors, with the aim of influencing the market's value? The answer for this question which encompasses small companies, which don't have enough means to communicate information to investors, might be 'yes', in that the cash dividends could be the most efficient means of communicating information in such companies. As to large companies, which are supposed to possess sufficient means of communicating information to multiple investors with a view to narrow the information gap between what investors know and what the company wants investors to know, the change in the cash dividends may not be the least costly way or the more efficient one for delivering such information. For example, the information may be transformed in the most efficient or less costly ways; and it may have the same change effect in the proportion of cash dividends through the analytical reports published and distributed by the company.
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