The Dividend Irrelevance Theory

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The dividend irrelevance theory (Modigliani and Miller, 1961) shows that, in a perfect capital market, firm valuation is unaffected by dividend policy of the company. However, in a real world where both dividend income and capital gains are taxed, investors will form different groups or clientele according to their effective tax brackets. Miller and Scholes (1978) shows that the preference for dividend or capital gains depends upon tax level. They indicate that companies that pay high (low) dividends will attract investor that like (dislike) dividends.
In the study of the roles of dividends, Black (1976) poses an interesting question that if companies can make a payment in cash by using lower-taxed methods such as share repurchase, why should …show more content…

Later, several studies provide indirect evidence of tax dividend clientele by examining price around dividend events. In the early study of dividend clientele, Elton and Gruber (1970) find that on the ex-dividend day, the stock price drops less than the amount of dividend paid. Due to investors’ concern for after‐tax returns, a higher tax on dividend income than on capital gains will result in an ex‐dividend day price drop that is smaller than the dividend. Afterwards, many studies find some evidence consistent with tax-based dividend clientele. Graham and Kumar (2006) examine individual investor trading behavior around ex-dividend days and dividend announcements. The result shows that individual investors’ demand for yield increases with age and decreases with income, consistent with dividend clienteles. They indicate that firms that pay higher dividends attract low income and older investors. Low income and older investors buy stocks on the day that dividends are announced until the ex-dividend …show more content…

The early studying is not focus on tax clientele. They just put the dividend yield as an independent variable in regression of only aggregate institutional ownership. For example, Gompers and Metrick (2001), they examine institutional investors and stock prices in US from 1980 to 1996 and find that there is no relationship between dividend yield and institutional ownership. Grinstein and Michaely (2005) examine the relation between institutional ownership and payout policy. The result shows that institutional investors prefer dividend-paying firms to non-dividend paying firms. However, according to dividend-paying firms, institutional investors are more likely to hold low dividend-paying stocks. It should be noted, however, that stock repurchase had just been allowed before sample period. Subsequently, Lee et al. (2006) examine the relationship between dividend clientele and ownership structure in Taiwan stock market where the capital gain tax is zero and share repurchase is not allowed during the sample period. The findings show that higher taxed investors prefer lower dividend-paying stocks and tend to sell stocks that raise dividends. Henry (2011) also examines investors’ dividend preferences and ownership structures in Australia market where there is a full dividend imputation system. The finding is consistent with tax clientele preference. However, some papers show

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