The paper starts by examining the effect of taxes on earning of a corporation in respect of dividends & capital gains. In the journal article prepared by (Brennan, 1970) he asserted through the work of (Selwyn, 1967) that “corporate earnings are paid out entirely as dividends and are taxed as personal income.” In addition to this, (Selwyn, 1967) also stated that “corporate earnings are translated into capital gains with all gains being realised immediately by investors and taxed at capital gains rates.” (Selwyn, 1967) Further developed a model which calculates “the operating income per share of the entity before interest and tax payments.” By partially differentiating the model with respect to; the amount of corporate debt outstanding per share of common stock (Dc) & the amount of personal debt outstanding per share of common stock (Dp), we get the cost of personal & corporate debt. Which the results assert through (Selwyn, 1967) that; Tp > Tg + Tc + TgTc Where; Tp, Tg, Tc, denote the “marginal personal income, capital gains & corporate tax rate.” The above verifies that the tax rate on personal income exceeds the tax rate on capital gains cumulated with the tax rate of corporations. The paper further explains why in spite of the above, firms still prefer paying dividends which have a higher cost as opposed to capital gains.
Signaling Theory According to this theory in an imperfect information setting, dividends act like a signal to investors from management on the expected cash flows of the firm. Bhattacharya 1979(p.260) ignored other sources of information such as account reports, on the basis that they are unreliable alone as they contain moral hazard when reporting profitability. A reason for a firm to pay dividends is, Martin Feldstein and Jerry Green 1983(p.2) if a firm decides to opt increasing retained earnings; it will negatively affect return on capital and increase the total level of investment. Also having increased retained earnings could completely or partially replace debt finance, hence affecting capital structure of the firm. Litner (1956) and Fama and Babier (1960) found a positive liaison between the annual dividend paid by a firm and the earnings of the firm that agrees in harmony with the perspective that firms will normally increase or pay-out high dividends with their earnings. This will therefore signal to outside investors the performance of the firm, hence increasing the cash flow of the firm as it attracts new investors. Agency Cost of Dividend Policy Giving out dividends reduces the agency problem between shareholders and management, the reason being that there is a reduction in discretionary funds available to management. Dividends hedge against the chance of a firm going bankrupt before there is a distribution of saved up assets. If we assumed that managers are not perfect agents in the corporate venture, but that they pursue their own interests when they can, and because the managers are not the residual claimants to the firm’s income stream, there might be a considerable deviation between their interests and those of the other participants. Given the existence of debt, managers can control the amount of risk and one way they can is by selecting a dividend policy. If managers first issue debt and then go on to finance new projects with retained earnings, the debt-equity ratio will fall. The lower it falls, the managers’ risk is lowered and the greater the benefits given on the debt holders, who will then receive their interest rate but escape the risk. Financing projects out of retained earnings if unanticipated by bondholders-transfers wealth Dividends can a keep firm in the capital market where there is monitoring of managers at a lower cost, may be beneficial in amending the level of risk taken on by managers and the different investor class. This explanation offers hope of accepting why firms instantaneously pay out dividends and raise new funds in the capital market. Bird-in-hand theory This viewpoint states that there is a direct relationship between firm dividend policy and market value. Closely related to the signalling idea is the notion that shareholders distrust the management and fear that retained earnings will be wasted in poor investments, higher management compensation, etc. According to this argument, in the absence of taxation shareholders would clearly prefer “a bird in hand” and this preference is strong enough to pressure management to make dividend payments even when this involves a tax penalty. The arguments are attributed to Gordon and lintner who suggested that there is in fact a direct relationship between dividend policy and a firm’s market value. Fundamental to this proposition is their ‘bird-in-hand argument, which suggests that investors see current dividends as certain and therefore less risky than capital gains. Investors are risk averse and therefore prefer present dividends as opposed to future gains. ‘A bird in the hand is worth two in the bush,” (Harcourt, 2002) .Gordon and Lintner argue that current dividend payments reduce investor uncertainty, causing investors to discount the firms earnings at a lower rate, ceteris paribus, to place a high value on the firm’s stock. Conversely, if dividends are reduced or not paid, investor uncertainty will increase, raising the required return and lowering the stock’s value therefore this may be taken as a reason why most firms prefer, in spite of the personal tax differential in favour of capital gains, pay out a large share of their earnings as dividends. (J & J, 2012) Investors deem returns of firms as unique and would prefer to receive dividends and thus giving them an opportunity to diversify their investment.
As noted by (Brigham, 2007) “when deciding on how much of the firm’s profits to be distributed out to stockholders, the financial managers always bear in mind that the firm’s primary objective is to maximise shareholder wealth and this paying out of dividends should be based in large part on investor’s preference for dividends versus capital gains.” (Brigham, 2007) further stated that “according to the Clientele Effect dividend theory, different groups of stockholders prefer different dividend pay-out policies. Now, with this being said, stocks of these firms that tend to pay out more of their earnings as dividends tend to attract those investors that are interested in a sure dividend today as opposed to an uncertain future capital gain as explained by the Clientele Effect.” Over & above this, (Brigham, 2007) asserted that “how much of the profits of the firm are distributed out to investors as dividends sometimes tend to depend on the investment opportunities available to that particular firm. Research has shown that firms in mature and very profitable industries where very few investment opportunities exist tend to pay out large proportions of their earnings to investors as dividends because there limited opportunities. The opposite has also been proved to be true for firms with a number of profitable opportunities available to them.” According to other researchers, another reasonable explanation of why firms would opt to pay out large proportions of their earnings as dividends is because of the issue of separation and ownership of the firm. They state that the financial managers would pay dividends to stockholders to communicate the level of growth of real income of the firm because the financial reports of the firm do not fully outlay some aspects such as the future prospects of the firm.” (Feldstein, 1983) “Another explanation of why firms would opt to pay dividends as opposed to capital gains as explained by some researchers is that, elderly investors who are shareholders are probably subject to lower tax rates. Pettit (1977), during his study, found out that there is a positive relationship between the ages of investors and the dividend yield of the portfolios they hold. He further continued to explain why firms pay out dividends by stating that is so because these elderly investors depend on this current income from their investments for current consumption and also that they do so to avoid transaction costs.”
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