Question

Nancy always invests in firms that pay dividends. She believes that when firms increase dividend, firm value will increase. Use two dividend theories to support and explain Nancy’s belief.

Answer 1

There are many scholars and investors who go by the belief that dividends are relevant from company valuations perspective and we look at two theories briefly below:

a. Bird in the hand theory: proposed by Gordon & Lintner, the theory proposes that the equity investors who are not entitled to any fixed return, can receive pay outs from equity either in the form of dividends or capital gains (from price appreciation). SInce the investors are risk averse they would value a certain dividend today compared to possible future capital gains through price appreciation, and hence a firm paying dividends consistently (even better growing dividends) will be favoured by investors and hence its valuation will improve. In its simplest form, as per the Gordon model for a steady stream of perpetual dividends, capital cost of r and growth of dividends at g, the firm value is expected to be : Firm Equity Value = Dividend / (r - g) . As we can see that the firm value is directly proportional to the dividend pay out

d. Dividend signalling theory: The dividend pay outs tend to be sticky and firms are reluctant to decrease dividend payouts unless there is a pressing need . Since the managers of the firm are expected to have better information about the future prospects of the firm, when they increase dividend pay outs it is is seens as a positive sign by investors because it denotes that the managers are more confident of the company's future prospects. This generally leads to better valuations and improvement in the company stock prices. Hence in this case also the firm value is proposed to be directly proportional to dividend payouts and the dividend pay out trajectory.