Myron Gordon and John Lintner argued that the cost of equity, rs, -Select-increasesdecreasesItem 2 as the dividend payout is increased because investors are less certain of receiving -Select-capital gainsinterest paymentsdividend paymentsItem 3 that should result from retaining earnings than they are of receiving -Select-capital gainsinterest paymentsdividend paymentsItem 4 . MM named this theory the bird-in-the-hand fallacy. MM believed that the cost of equity was independent of dividend policy, which implies that investors are indifferent between dividends and capital gains.
However, the Tax Code encourages many individual investors to prefer capital gains to dividends. Taxes must be paid on dividends the year they are received; however, taxes on capital gains are not paid until the stock is sold. Due to time value effects, a dollar of taxes paid in the future has a -Select-higherlowerItem 5 effective cost than a dollar of taxes paid today.
An increase in the dividend is often accompanied by an increase in the stock price, while a dividend cut generally leads to a stock price decline. This observation led to the -Select-dividend irrelevanceinformation (signaling)cateringItem 6 theory, which states that investors regard dividend changes as indicators of management's earnings forecasts. Managers often have better information about future prospects for dividends than public stockholders, so there is some information content in dividend announcements. A firm should consider these effects when it is contemplating a change in dividend policy.