The terms “irrelevance,” “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 what these terms mean, and briefly describe each theory.

Integrated Waveguide Technologies (IWT) is a 6-year old company founded by Hunt Jackson and David Smithfield to exploit metamaterial plasmonic technology to develop and manufacture miniature microwave frequency directional transmitters and receivers for use in mobile Internet and communications applications. The technology, although highly-advanced, is relatively inexpensive to implement and their patented manufacturing techniques require little capital in comparison to many electronics fabrication ventures. Because of the low capital requirement, Jackson and Smithfield have been able to avoid issuing new stock and thus own all of the shares. Because of the explosion in demand for its mobile Internet applications, IWT must now access outside equity capital to fund its growth and Jackson and Smithfield have decided to take the company public. Until now, Jackson and Smithfield have paid themselves reasonable salaries but routinely reinvested all after-tax earnings in the firm, so dividend policy has not been an issue. However, before talking with potential outside investors, they must decide on a dividend policy.
Your new boss at the consulting firm Flick and Associates, which has been retained to help IWT prepare for its public offering, has asked you to make a presentation to Jackson and Smithfield in which you review the theory of dividend policy and discuss the following issues.

Dividend irrelevance refers to the theory that investors are indifferent between dividends and capital gains, making dividend policy irrelevant with regard to its effect on the value of the firm. “Bird-in-the-hand” refers to the theory that a dollar of dividends in the hand is preferred by investors to a dollar retained in the business, in which case dividend policy would affect a firm’s value.
The dividend irrelevance theory was proposed by MM, but they had to make some very restrictive assumptions to “prove” it (zero taxes, no flotation or transactions costs). MM argued that paying out a dollar per share of dividends reduces the growth rate in earnings and dividends, because new stock will have to be sold to replace the capital paid out as dividends. Under their assumptions, a dollar of dividends will reduce the stock price by exactly $1. Therefore, according to MM, stockholders should be indifferent between dividends and capital gains.
The dividend preference, or “bird-in-the-hand” theory is identified with Myron Gordon and John Lintner, who argued that investors perceive a dollar of dividends in the hand to be less risky than a dollar of potential future capital gains in the bush; hence, stockholders prefer a dollar of actual dividends to a dollar of retained earnings. In addition, high payouts mitigate agency costs by depriving managers of cash to waste and by causing companies to go to the external capital markets more often (which leads to greater scrutiny and less misuse of resources by managers). If the bird-in-the-hand theory is true, then investors would regard a firm with a high payout ratio as being less risky than one with a low payout ratio, all other things equal; hence, firms with high payout ratios would have higher values than those with low payout ratios.
MM opposed the Gordon-Lintner theory, arguing that a firm’s risk is dependent only on the riskiness of its cash flows from assets and its capital structure, not by how its earnings are distributed to investors.
The tax effect theory recognizes that there are two tax-related reasons for believing that investors might prefer a low dividend payout to a high payout: (1) taxes are not paid on capital gains until the stock is sold. (2) if a stock is held by someone until he or she dies, no capital gains tax is due at all--the beneficiaries who receive the stock can use the stock’s value on the death day as their cost basis and thus escape the capital gains tax.