What is Gordon's Bird-in-the-Hand argument of dividend?

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What is Bird-in-the-Hand Theory?

The bird-in-the-hand argument of dividend means that the near-future dividends are worth more than a distant-future dividend of equal amount. It considers that investors are always risk averse and so, they will discount distant future gains (capital gains) more heavily than the near future ones. That is, if an investor is asked whether he prefers one bird in the hand or two in the bush, he will always select the former.

In other words, there are risks associated with dividends that are payable after a longer tenure than the ones that are paid in the near future. Investors therefore prefer to take less risk and ask for dividends as early as possible as opposed to a larger share as capital gains. This theory of asking for near-term dividends was first proposed by Krishman as the bird-in-the-hand theory.

Gordon’s Contribution

Myron Gordon has put forward the theory more convincingly. According to Gordon, uncertainty increases with passing time and this is also applicable to dividends. Therefore, as uncertainty levels go up with distant dividends, the risk to get a certain return or a heavier dividend gets diminished. Therefore, the risk-averse investors prefer to have dividends in the near future by discounting the rates of return less heavily than that is done in case of distant returns.

Gordon also argues that even in the case of the internal rate of return being equal to the opportunity cost of capital, there is an inequality in the nature of dividends that are paid in the near future and the ones that are paid later. Investors realize this risk and hence ask for a near-term dividend, neglecting the chance of getting a bigger capital gain in the long term.

According to Gordon, the distant dividends (capital gains) are discounted more than the near-future dividends due to the uncertainty factor which makes the dividends paid later less attractive for the investors. Therefore, to keep the investors content, a company must pay some added premium along with capital gains. This is not applicable to near-term dividends as they are paid with more certainty.

Conclusion

It is easy to realize why distant dividends feel less worthy if we apply the concept of time value of money. As an amount paid in the distant future loses value, it is perfect to intend to get the amount as early as possible. This translates into the bird-in-the-hand theory in the case of dividend payouts. However, as dividend payouts may not be equal and there may be differences in current and future payouts, it is usually easier to discount the rates according to the tenure of the dividend payout periods.

raja
Updated on 25-Mar-2022 05:38:14

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