Bird in the hand theory

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 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. 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".           

The key implication, as argued by Litner and Gordon, is that because of the less risky nature
dividends, shareholders and investors will discount the firm's dividend stream at a lower rate of
return, "r", thus increasing the value of the firm's shares.

According to the constant growth dividend valuation (or Gordon's growth) model, the value of an
ordinary share, SV0 is given by:

            SV0 = D1/(r-g)

Where the constant dividend growth rate is denoted by g, r is the investor's required rate of
return, and D1, represents the next dividend payments. Thus the lower r is in relation to the value
of the dividend payment D1, the greater the share's value. In the investor's view, according to
Linter and Gordon, r, the return from the dividend, is less risky than the future growth rate g.
Thus, 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).

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. Thus, the investors 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.

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 retention. 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 retention 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.
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). The change in
dividend payment is to be interpreted as a signal to shareholders and investors about the future
earnings prospects of the firm. 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.

Generally a rise in dividend payment is viewed as a positive signal, conveying positive

information about a firm's future earnings prospects resulting in an increase in share price.
Conversely a reduction in dividend payment is viewed as negative signal about future earnings
prospects, resulting in a decrease in share price.

Residual theory of divided policy:

 The essence of the residual theory of dividend policy is that the firm will only pay dividends
from residual earnings, that is, from earnings left over after all suitable (positive NPV)
investment opportunities have been financed. Retained earnings are the most important source
for financing for most companies. A residual approach to the dividend policy, as the first claim
on retained earnings will be the financing of the investment projects. With the residual dividend
policy, the primary focus of the firm's management is indeed on investment, not dividends.
Dividend policy becomes irrelevant. The view of management in this case is that the value of
firm and the wealth of its shareholders will be maximized by investing the earnings in the
appropriate investment projects, rather than paying them out as dividends to shareholders.
Dividends will only be paid when retained earnings exceed the funds required to finance the
suitable investment projects. Conversely when the total investment funds required exceed
retained earnings, no dividend will be paid.
 Motive for a residual policy
            The motives for a residual policy, or high retentions, dividend policy commonly include:

1. A high retention policy reduces the need to raise fresh capital, (debt or equity), thus
saving on associated issues and floatation costs.
2. A fresh equity issue may dilute existing ownership control. This may be avoided, if
retentions are consistently high.
3. A high retention policy may enable a company to finance a more rapid and higher rate of
growth.

When the effective rate of tax on dividend income is higher than the tax on capital gains, some
shareholders, because of their personal tax positions, may prefer a high retention/low payout
policy

 Dividend Irrelevancy Theory

Dividend irrelevancy theory asserts that a firm's dividend policy has no effect on its market value
or its cost of capital. The theory of dividend irrelevancy was perhaps most elegantly argued by
its chief proponents, Modigliani and Miller (usually referred to as M&M) in their seminar paper
in 1961. They argued that dividend policy is a "passive residual" which is determined by a firm's
need for investment funds.

            According to M&M's irrelevancy theory, if therefore does not matter how a firm divides
its earnings between dividend payments to shareholders and internal retentions. In the M&M
view the dividend decision is one over which managers need not agonies, trying to find the
optimal dividend policy, because an optimal dividend policy does not exist. M&M built their
dividend irrelevancy theory on a range of key assumptions, similar to those on which they based
their theory of capital structure irrelevancy. For example they assumed:

1. Perfect Capital markets, that is there are no taxes, (corporate or personal), no transaction
costs on securities, investors are rational, information is symmetrical – all investors have
access to the same information and share the same expectations about the firm's future as
its managers.
2. The firm's investment policy is fixed and is independent of its dividend policy.