The terms “irrelevance,” “dividend preference,” or “bird-in-the-hand,” and “taxeffect” have been used to describe three major theories regarding the waydividend payouts affect a firm’s value. Explain these terms, and briefly describeeach theory
Dividend Irrelevance Theory
This is a theory that was originally proposed by Franco Modigliani and Merton Millier (MM). The theory claimed that the value of a company is established only by its business risks and basic power of earning. In this theory, the company’s value relies only on the income generated by its assets, and not on how the earnings are divided between retained and dividends earnings. The dividend irrelevance theory principle conclusion is that dividend policy fails to impact a risk or value of stock. Thus, it does not impact the needed return rate on equity (Al-Malkawi et al., 2010).
This theory was created by John Lintner and Myron Gordn who contrasted the MM theory by arguing that risk of a stock reduces as dividends increase. This means a return in dividends form is asure thing, though a return in the capital gains form is risky. Thus, shareholders have a preference for dividends and they are willing to assent a lower needed return on equity; “bird in a hard is worth more than two in the bush”. The theory beliefs that high payouts lower the risk of cash squandering since the cash on hand is less. Moreover, a high-payout firm has to raise extra cash more frequently compared to a low-payout firm. When a manager is sure that the firm will experience frequent external markets scrutiny, the manager then will be less probable to participate in wasteful practices. Thus, high payouts lower the agency costs risk, which makes shareholders to be more than willing to accept a lower needed return on equity (Al-Malkawi et al., 2010).
Tax Effect Theory
The theory demonstrates how taxes payment affects the stock and the dividend. Stock price is said to be more favorably taxed compared to dividend and thus, most stockholders would prefer taking stock compared to dividend due to taxes involved. Even when the two are taxed at the same rate, stock tax rate is considered to be more favorable since stock’s price increase is not taxable until the stock is sold by the investor.
Read also Accounting Theory – Deferred Taxes
On the contrary dividend payment is immediately taxed, and a dollar a future paid tax contain less effective cost compared to a dollar paid today due to the time value of money. Thus, even when gains and dividends are equally taxed, capital gains are not taxed sooner compared to dividends. Moreover, in case a stock is held up to when a shareholder dies, no capital gains tax is at all due then. The beneficially can enjoy the stock value without any tax expenses.
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