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Discuss the bird in the hand theory of dividend policy.

The essence of the bird-in-the-hand theory of dividend policy (advanced by John Litner in 1962 and Myron Gordon in 1963) is that shareholders are risk-averse and prefer to receive dividend payments rather than future capital gains. Shareholders consider dividend payments to be more certain that future capital gains - thus a "bird in the hand is worth more than two in the bush". Under conditions of uncertainty, investors tend to discount distant dividends (capital gains) at a higher rate than they discount near dividends. Essentially, investors are risk averse and have therefore a preference for near to future dividends. This is the basis of bird in hand argument. According to Kirshman (1969), stockholders often act upon the principle that a bird in the hand is worth two in the bush and for this reason, they are willing to pay a premium for the stock with the higher dividend rate. Similarly, according to M.Gordon, when dividend policy is considered under uncertainty, the discount rate cannot be assumed to be constant. In fact, the lower the current dividend, the higher the retention rate of profits. Thus, the appropriate discount rate will increase with retention rate since distant dividend are more uncertain than near dividend. As discount rate increases with length of time (future is uncertain), a low dividend payment in the beginning will tend to lower the value of the firm.
P0 D3 Dt D1 D2 .......... .. 2 3 1 r1 1 r 2 1 r 3 1 rt t

rt>.>r2>r1 : discount rate increases with length of time.

Argument: Dividends are better than capital gains because dividends are certain and capital gains are uncertain. So, risk-averse investors prefer dividends. Response: Firm value is determined by the cash flows from the project. If a firm increases dividends, it will have to sell new shares to satisfy investment requirements. What is received as dividends will be offset by loss of price appreciation. The new investors who bear the risk that the old investors avoid need to be compensated.