Clientele Effect

Different groups of investors (called clienteles) prefer different dividend policies. Investors who want current investment income should own shares in high dividend payout firms, while investors with no need for current investment income should own shares in low dividend payout ratio. The clientele effect suggests that a firm will attract investors who like the firm's dividend payout policy. After every investor has made the choice, the market is in equilibrium, and each firm serves its own clientele.

Evidence from several studies suggests that there is in fact a clientele effect and a preference for dividends is one way in which the equity market can be segmented.

The clientele effect would suggest that certain investors might be drawn to certain industry groups because of the dividend yield. The implication is: dividend policy should be stable. Management should avoid changing its dividend policy frequently since a change might cause current shareholders to sell their stock, forcing the stock price down. Current clientele may pay brokerage costs and capital gains taxes to sell their stock, and there may not be many investors (new clientele) who like the new dividend policy.

In 1970 Elton and Gruber showed that if taxes enter investors' decisions, then the fall in price on the ex-dividend day should reflect the post-tax value of the dividend relative to the post-tax value of capital gains on that day. Because dividends in most time periods are taxed more heavily than capital gains, the theory suggests that if taxes affect investors' choices, the fall in stock price should in general be less than the dividend, and the drop could be used to infer marginal tax rates.

The expected ex-dividend day decline in price when the decline is affected by tax rates is easy to determine. If the investor is considering selling shares either before or on the ex-dividend date, the equilibrium choice is derived as follows. Let

1. P_b be the cost of a share
2. P_w be the price of a share the day before the stock goes ex-dividend
3. P_x be the price of the stock the day the stock goes ex-dividend
4. T_CG be the capital gains tax rate
5. T_D be the tax rate on dividend income

The investor is indifferent as to timing if

P_w - T_CG(P_w - P_b) = P_x - T_CG(P_x - P_b) + D (1 - T_D)

Rearranging the above equation, we obtain:

The drop in price on the ex-dividend day is less than amount of the dividend when ordinary (dividend) income tax rates exceed capital gains tax rates.

Signaling Effect: The Information Content of Dividends

One of MM's assumptions is that investors and managers have the same information about the firm's prospects. This is called symmetric information. In reality, managers often have better information than outside investors. This is called asymmetric information.

It has been observed that an increase in the dividend is often accompanied by an increase in the price of a stock, while a dividend cut generally leads to a stock price decline. This could indicate that investors, in the aggregate, prefer dividends to capital gains. However, MM argue dividend policy should take account of the information content of dividends (signaling). This relates to the fact that investors regard an unexpected dividend change as a signal of management's forecast of future earnings.

• Managers have better information about a firm's future prospects than outside investors.

• Investors may regard dividend changes as signals of management's earnings forecast - only good firms can afford high dividends.
  • A higher-than-expected dividend increase signals a firm's good prospects and its managers' confidence in future cash flows.
  • Conversely, a dividend reduction or smaller-than-expected increase is a signal that managers are forecasting poor earnings in the future.

• Thus, stock prices rise when firms announce dividend increases, and fall when firms announce dividend cuts. This simply indicates that investors believe there is an important information content in dividend announcements.

Empirical studies of this subject have had mixed results. Furthermore, there is often a cultural or country-specific element to the signaling aspect of dividends. For example, where U.S. investors often infer significant signals in long-term expectations from even minor changes in a dividend, in some Asian countries, a dividend cut is not necessarily viewed as an unfavorable sign at all.

Still, signaling effects should definitely be considered when a firm is contemplating a change in dividend policy.

Agency Costs and Dividends

Agency theory argues that in corporations with diffused ownership, managers are often found to pursue their own goals instead of maximizing shareholder wealth when they are not closely monitored. This conflict of interests is manifest when managers are entrenched. They make value-destroying acquisitions, choose capital structures not in favor of shareholders' interests and even make decisions in favor of their own compensation. It is obvious to predict that managers prefer to cut or lower dividend payout if they become more entrenched based on agency theory since paying dividend reduces the amount of cash at managers' disposal, therefore they will get better capital market monitoring or do fewer inefficient investments. As Jensen points out, a policy of paying dividends reduces firms' agency costs by improving the monitoring and risk-raking incentives of managers.

Shareholders may want most of firm's cash paid out to them as dividends. Paying out a large cash dividend may dilute the existing debtholders' claim. The dividend reduces the firm's cash and its stockholders' equity increasing the risk of the debtholders' claims. Claim dilution via dividend policy is why many bond issues have some form of dividend restriction.