Introductory Corporate Finance: Dividend Policy - Bird-in-the-Hand Theory, Dividends Lower Risk Higher Value

What This Is

The Bird-in-the-Hand Theory, also known as the dividend preference theory, suggests that investors prefer current dividends over future capital gains. This theory implies that higher dividend payments lower the risk and increase the value of a company. For example, consider Tesla, Inc. (TSLA), which has a dividend yield of 0.03% compared to Apple Inc. (AAPL) with a dividend yield of 0.94%. Investors may perceive Apple as a lower-risk investment due to its higher dividend payments.

Key Formulas & Models

• Dividend Yield (DY) = Annual Dividends / Market Price: measures the ratio of annual dividend payments to the current market price of the stock.
• Dividend Payout Ratio (DPR) = Dividends / Earnings: measures the proportion of earnings paid out as dividends.
• Sustainable Growth Rate (SGR) = ROE × (1 - Retention Ratio): estimates the long-term growth rate of a company.
• Degree of Operating Leverage (DOL) = (Q(P - V) / (Q(P - V) - F)): measures the sensitivity of EBIT to changes in sales.
• Weighted Average Cost of Capital (WACC) = wd × rd(1 - T) + wps × rps + we × re: estimates the cost of capital for a company.
• Interest Tax Shield (ITS) = Interest Expense × Tax Rate: represents the tax benefit of interest payments.
• Free Cash Flow (FCF) = EBIT + Depreciation - Capital Expenditures - Change in Working Capital: measures the cash generated by a company's operations.

Step-by-Step Calculation

1. Calculate the dividend yield (DY) using the annual dividend payment and market price.
2. Determine the dividend payout ratio (DPR) by dividing the dividend payment by earnings.
3. Estimate the sustainable growth rate (SGR) using the return on equity (ROE) and retention ratio.
4. Calculate the degree of operating leverage (DOL) using the sales, variable costs, and fixed costs.
5. Estimate the weighted average cost of capital (WACC) using the cost of debt, cost of equity, and tax rate.
6. Calculate the interest tax shield (ITS) using the interest expense and tax rate.

Common Mistakes

1. Mistake: Using book value instead of market value for WACC.
   • Correction: Use market value to reflect the current market price of the company's assets.
2. Mistake: Ignoring flotation costs when calculating WACC.
   • Correction: Include flotation costs to accurately reflect the cost of issuing new debt or equity.
3. Mistake: Confusing sunk cost with opportunity cost.
   • Correction: Sunk costs are irreversible, while opportunity costs represent the value of alternative choices.
4. Mistake: Not considering the impact of taxes on the cost of debt.
   • Correction: Include the tax benefit of interest payments when calculating WACC.

Exam / CFA Tips

1. Tip: Be aware of the differences between M&M Proposition I (no taxes) and M&M Proposition II (with taxes).
2. Tip: Understand the distinction between dividend irrelevance and the bird-in-the-hand theory.
3. Tip: Be prepared to calculate WACC and ITS using different scenarios.

Quick Practice Problem

A company has EBIT of $10M, interest expense of $2M, and a tax rate of 25%. Calculate the degree of operating leverage (DOL).

Answer: DOL = (Q(P - V) / (Q(P - V) - F)) = (10M / (10M - 2M)) = 2.5

Explanation: The DOL measures the sensitivity of EBIT to changes in sales.

Last-Minute Cram Sheet

1. Dividend Yield (DY) = Annual Dividends / Market Price: measures the ratio of annual dividend payments to the current market price of the stock.
2. Dividend Payout Ratio (DPR) = Dividends / Earnings: measures the proportion of earnings paid out as dividends.
3. Sustainable Growth Rate (SGR) = ROE × (1 - Retention Ratio): estimates the long-term growth rate of a company.
4. Weighted Average Cost of Capital (WACC) = wd × rd(1 - T) + wps × rps + we × re: estimates the cost of capital for a company.
5. Interest Tax Shield (ITS) = Interest Expense × Tax Rate: represents the tax benefit of interest payments.
6. Free Cash Flow (FCF) = EBIT + Depreciation - Capital Expenditures - Change in Working Capital: measures the cash generated by a company's operations.
7. Degree of Operating Leverage (DOL) = (Q(P - V) / (Q(P - V) - F)): measures the sensitivity of EBIT to changes in sales.
8. In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.
9. The bird-in-the-hand theory suggests that investors prefer current dividends over future capital gains.
10. The dividend payout ratio (DPR) measures the proportion of earnings paid out as dividends.