Impact of Tax Consideration and Transitory Earnings on Dividend Inside a Firm.

Topics: Dividend, Progressive tax, Dividend yield Pages: 14 (4237 words) Published: September 6, 2011



The purpose of this paper is to discuss the Dividend Relevance Theory and to determine whether a relationship exists between dividend payment and transitory earnings; given the impact of tax and other economic conditions with the objective of maximizing the present discounted value of after tax dividend. To achieve this, the Lintner’s models were specified to which the OLS regression was used to estimate the impact of dividend payment on short term transitory earnings. A total of fifty (50) quoted Nigerian firms were examined and the result shows that a relationship exists between dividend payment and transitory earnings; given the effect of tax and other economic conditions.

Dividend relevance is a theory relating to the impact of dividends on organizations and individual investors. The theory advanced by Gordon and Linter, establishes that there is a direct relationship between a firms dividend policy and its market value. Investors respond to receiving actual cash returns. Gordon and Linter referred to this as the “Bird in hand theory”- another name for dividend relevance (de Boyrie, 2001). According to the Hewitt Investment Group. “Gordon and Linter asserts that dividends received today are preferable to future dividends, which are subject to uncertainty. Higher uncertainty will cause investors to ascribe a higher risk premium to those payments, thereby increasing a firms cost of capital (Hewitt, 2002). The essential element of the dividend relevance theory is the fundamental teaching that investors find current dividends less risky than future returns and will invest more, boosting stock prices. Gordon and Linter believe stockholders prefer current dividend and that this causes a positive relationship between dividend and market value.

The Lintner model of dividend payouts is one in which firms reconcile potentially conflicting goals of choosing dividends that are appropriate for current conditions while maintaining dividends close to their historic levels. The Lintner model is consistent with the following specification of firm’s objectives.

=1 (Dit- kit Eit)2 + 2 (Dit – Dit-1)2 ……………………………..1 In which firm i chooses a dividend policy that minimizes  (impact of tax and other economic conditions on the desirability of paying dividends out of current earnings). In the equation (1), Dit is firm i’s dividend in period t, kit is its target retention ratio in period t and Eit is it’s after tax earning in period t. 1 and 2 are parameters that are common to all firms. The first term on the right side of (1) reflects the cost that firm i incurs when its dividend in period t differ from target dividends, while the second term reflects the cost of deviating from the previous period dividend. The quadratic specification of (1) implies that these costs are symmetric around desired dividend (in the first case) and the previous year’s dividend (in the second case); the specification requires that 1 > 0 and 2 > 0.

The first term in (1) reflects the impact of tax and other economic conditions on the desirability of paying dividends out of current earnings. The parameter kit is the payout rate that maximizes the present discounted value of after tax dividends in the absence of corporate control consideration. As a general matter, kit is likely to be a function of contemporaneous tax rates and other variables. The second term in (1) stems from the difficulty of maintaining appropriate incentives while permitting dividends to fluctuate with earnings. Strictly adherence to target dividends gives manager strong incentives to generate sufficient cash flows to finance such dividends, and may thereby enhance profitability over the long run.

The implication of minimizing  can be identified by differentiating (1) with respect to Dit...
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