Question

The terms “irrelevance,” “dividend preference” (or “bird-in-the-hand”), and “tax effect” have been used to describe three major theories regarding the way dividend payouts affect a firm’s value. Explain these terms, and briefly describe each theory.

What do the three theories indicate regarding the actions management should take with respect to dividend payouts?

for me to give you a thumbs up I need a paragragh for each question.

Answer 1

There are different types of dividend theories and different theory states different things. Some theory says that dividend does matter while some state that it does not.

· Dividend irrelevance states that whether the dividend is paid or not it does not affect the investors perception towards the company and the company can either choose to pay dividend or reinvest the proceeds and provide capital gains to the investor in terms of price appreciation of the share price of the company. The irrelevance theory states that investors are indifferent between dividend gain or capital gain.

· Bird in the hand theory says that investor prefer stocks which pays dividend rather than waiting for capital gain because that capital might or might not happen so it is better to receive dividend. According to this theory companies which pays high and stable dividend, generally they are desirable in the market and their valuations can be positively affected in the eyes of the investors.

· The tax preference theory says that investors take into account the effect of taxation on their income from stock and on the basis of that their decision may be affected. Normally dividends are taxed as ordinary income rate and capital gains are treated at lower rates, so if the dividend tax rate is higher than capital gains tax rate, investors would be willing to let go off the dividend in order to get large capital gains.

In real world scenario the management can not ignore the perception of the investors towards the stock price of the company so most companies do pay attention to the dividend aspect. The three theories say different things, irrelevance says dividends does not matter, while the bird in the hand theory says it is better to have dividend today rather than waiting for the capital gain which might or might not happen. The tax preference theory says investors prefer dividend when the dividend tax rate is low. In real world most companies choose to follow a dividend policy where they are following a stable dividend policy but companies which are young age, they do not choose to pay dividend but rather reinvest for capital gains.