15.4How Dividend Policy Affects Expected Stock Returns

We have asserted that share repurchases provide a better method of distributing cash

than dividends because most investors prefer capital gains income to an equivalent

dividend taxed at a higher rate. Stocks with higher dividend yields, to compensate

investors for their tax disadvantage, should thus offer higher expected returns than

similar stocks with lower dividend yields. Firms with higher dividend yields, but

equivalent cash flows, should then have lower values, reflecting the higher rates that

apply to their cash flows.

Researchers have taken two approaches to evaluate the effect of dividend yield on

expected stock returns. The first approach measures stock returns around the date that

the stock trades ex-dividend. Recall from Chapter 8 that the ex-dividend date(or the

ex-date) is the first date on which purchasers of new shares will not be entitled to

receive the forthcoming dividend. For example, a dividend paid on February 15 may

have an ex-dividend date of February 5, which means that purchasers of stock on and

after February 5 will not receive the dividend. Since investors who purchase the stock

before the ex-dividend date (February 4 or earlier in this example) receive the dividend

while those who purchase stock on or after this date do not, the decline in the stock

price on the ex-dividend date provides a measure of how much the market values the

dividend. The second approach measures how dividend yield affects expected returns

cross-sectionally.

⁷See Black (1976) for an early discussion of this dividend puzzle.

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543

Ex-Dividend Stock Price Movements

Consider Example 15.4, which assumes that a dividend is taxed at an investor’s per-

sonal income tax rate and that capital gains are not taxed at all.

Example 15.4:The Decision to Purchase Stock Before orAfterthe

Ex-Dividend Date

Trevtex Corporation plans to pay a dividend of $1 per share.Tomorrow is the ex-dividend

date, so investors who purchase the stock tomorrow will not receive the dividend.Assume

Trevtex is selling for $20.00 per share today and is expected to sell for $19.20 per share

tomorrow.Should an investor with a 33 percent marginal tax rate, who is not taxed on cap-

ital gains, purchase the stock today and receive the dividend or should the investor wait one

day and purchase it without the dividend?

Answer:The net cost per share of buying the stock with the dividend is $20 minus $1

for the dividend plus the tax the investor must pay on the imminent dividend.For an investor

with a 33 percent marginal tax rate, this net cost is $19.33 per share.Hence, purchasing

the stock ex-dividend for $19.20 per share would be preferred to purchasing the stock for

$20 per share just prior to the ex-dividend date, which has a net cost of $19.33.However,

a tax-exempt investor would prefer to purchase the stock prior to the ex-dividend date since

the net cost per share is $19 ( $20 $1).

Example 15.4 illustrates that a $1 dividend may be worth less than $1 because

of personal taxes that investors must pay on the dividends. As a result, stock prices

will drop by less than the amount of the dividend on the ex-dividend date. For

instance, the stock price would fall $0.67 after the payment of a $1.00 dividend if

the marginal investor, who would be indifferent between buying either before or after

the ex-dividend date, had a 33 percent tax rate on dividends, assuming that there is

no tax on capital gains.

Empirical Evidence on Price Drops on Ex-Dividend Dates.Elton and Gruber

(1970) examined the price movements around the ex-dividend dates of listed stocks

from April 1966 to the end of March 1967. They found that, on average, the stock price

decline was 77.7 percent of the dividend, implying that shareholders place a value of

only slightly more than $0.77 on a dividend of $1.00. The authors also found that the

percentage price drop was related to the size of the dividend. For dividends greater than

5 percent of the stock price, the price drop on the ex-dividend date exceeded, on aver-

age, 90 percent of the dividend. For the smallest dividends, however, the price drop on

the ex-dividend date was closer to 50 percent of the dividend.

Elton and Gruber interpreted the differential price drop as evidence of the investor

clientele effect. Because the marginal investor in a stock with a high dividend yield is

likely to have a low marginal tax rate, the after-tax value of the dividend should be rel-

atively close to the amount of the payout. However, the marginal buyer of a stock with

a low dividend yield is likely to have a high marginal tax rate and thus will place a

much lower value on the dividends.

Non-Tax-Based Explanations forthe Magnitudes of the Ex-Dividend Date Price

Drops.Asecond explanation for the differential price drop was suggested by Kalay

(1982). To understand this explanation, consider first the case where there are no trans-

action costs. In this case, if the stock price drop was not close to the amount of the

dividend, traders would have an opportunity to earn arbitrage profits. In Example 15.4,

traders could buy the stock at $20.00, receive the $1.00 dividend, and sell the stock the

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544Part IVCapital Structure

next day for $19.20. Because the capital loss from the price drop is fully tax deductible

at the personal income tax rate for short-term traders, this transaction yields an after-

tax as well as a pretax gain. This arbitrage gain will exist as long as the price does not

drop by the full amount of the dividend.

Consider next the case where there is a $0.10 per share transaction cost. In this

case, the price need not drop the full $1.00, but it must drop at least $0.90, or 90 per-

cent of the dividend, to preclude arbitrage. However, on a $0.40 dividend, the price

needs to drop only $0.30, or 75 percent of the dividend, to preclude arbitrage. Hence,

for smaller dividends, smaller price drops as a percentage of the dividend are needed

to preclude arbitrage, which is exactly what Elton and Gruber observed. Consistent with

this, if prices are set to preclude arbitrage, then returns on the ex date which include

the dividend should be independent of the amount of the dividend. This means that on

the margin, a one cent increase in the dividend should lead to a one cent increase in

the price drop. Astudy by Boyd and Jagannathan (1994) found that this was indeed

the case.

Other evidence leads us to suspect that the observed behavior of stock prices on

ex-dividend dates may have nothing to do with taxes. First, the kind of behavior

observed on the ex-dividend date in the United States seems to be an international phe-

nomenon, even where dividends are not tax disadvantaged. Frank and Jagannathan

(1998) observed that in Hong Kong, where dividends are not taxed, stock price changes

on ex-dividend dates are similar to those observed in the United States. This finding

may have been due to an inefficient share registration system, which Hong Kong fixed

in 1993, as stock price drops on ex-dividend dates since 1993 have averaged about 100

percent of the dividend. In addition, stock prices also fall by much less than the amount

of the dividend on the ex-dividend dates of stock dividends. Since stock dividends are

not taxed, one cannot use a tax-based story to explain the stock price behavior around

the time of ex-dividend dates for stock dividends.⁸

The Cross-Sectional Relation between Dividend Yields and Stock Returns

If a firm’s dividend policy is determined independently of its investment and operat-

ing decisions, the firm’s future cash flows also are independent of its dividend policy.

In this case, dividend policy can only affect the value of a firm by affecting the expected

returns that investors use to discount those cash flows. For example, if dividends are

taxed more heavily than capital gains, then, as noted earlier, investors must be com-

pensated for this added tax by obtaining higher pretax returns on high-dividend yield-

ing stocks. (They would not hold shares in such stocks and supply would not equal

demand if this were not true.)

Stocks with high dividend yields do, in fact, have higher returns, on average, than

stocks with low dividend yields. However, Blume (1980) documented that the rela-

tionship between returns and dividend yield is actually U-shaped. Stocks with zero div-

idend yields have substantially higher expected returns than stocks with low dividend

yields, but for stocks that do pay dividends, expected returns increase with dividend

yields. This finding is consistent with the idea that stocks with zero dividend yields are

extremely risky, but for firms that pay dividends, higher dividends require higher

expected returns because of their tax disadvantage.

⁸Studies by Eades, Hess and Kim (1984) and Grinblatt, Masulis, and Titman (1984) document

positive returns on ex-dates for stock dividends and stock splits.

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Chapter 15

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545

To test whether a return premium is associated with high-yield stocks, a number

of studies estimate cross-sectional regressions of the following general form:⁹

R a Divyld	(15.3)
j 1j2jj

where

the firm’s beta

j

Divyldthe firm’s expected dividend yield¹⁰

j

the error term.

j

The hypothesis is that , which measures the effect of dividend yield on required

2

returns, is positive to reflect the tax disadvantage of dividend payments, and that ,

1

the coefficient of beta, is positive to reflect the effect of systematic risk on returns.

Most of these studies found that the coefficient of the expected dividend yield was pos-

itive, which they interpreted as evidence favoring a tax effect.

These interpretations assume that the beta estimates used as independent variables

in the regression in equation (15.3) provide an adequate estimate of the stocks’risks.

However, as discussed in Chapter 5, finance academics find weak support for the idea

that market betas provide a good measure of the kind of risk that investors wish to

avoid. Distinguishing between tax and risk effects is further compounded by the rela-

tion of the dividend yield to other firm characteristics that are likely to be related to

risk and expected returns. For example, Keim (1985) showed that both firms paying

no dividends and firms paying large dividends were primarily small firms. This sug-

gests that the expected dividend yield may be acting as a proxy for firm size in the

regression shown in equation (15.3). In addition to being related to firm size, dividend

yield is correlated with a firm’s expected future investment needs and its profitabil-

ity—both attributes that are likely to affect the riskiness of a firm’s stock.

Result 15.4

Stocks with high dividend yields are fundamentally different from stocks with low dividendyields in terms of their characteristics and their risk profiles. Therefore, it is nearly impos-sible to assess whether the relation between dividend yield and expected returns is due totaxes or risk.

Since it may be impossible to detect whether paying dividends increases a firm’s

required expected rate of return, one cannot be certain that a policy of substituting share

repurchases for dividends will have a lasting positive effect on the firm’s share price.

Although some articles by finance academics claim that dividends increase a stock’s

required rate of return, these studies are open to interpretation.

⁹The first study to test this specification was Brennan (1970), who concluded that there was a return

premium associated with stocks that have high dividend yields.

¹⁰The

expected dividend yield rather than the actual dividend yield must be used in these regressions

because of the information content of the dividend choice. For example, a firm that pays a high dividend

in a given year is likely to have a high return in that year because of the favorable information conveyed

by the dividend increase (which we will discuss in detail in Chapter 19). Miller and Scholes (1982)

pointed out that this information effect was ignored in the early studies on this topic, and, as a result, the

purported finding of a tax effect was spurious. However, Litzenberger and Ramaswamy (1982) measured

an expected dividend yield, using information available prior to the time the returns were measured, and

found the coefficient of the expected dividend yield to be positive and statistically significant, supporting

the hypothesis of a tax-related preference for capital gains.

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546Part IVCapital Structure

Citizens Utilities

Citizens Utilities provides an interesting case study for examining the effect of dividend

yields on prices. From 1955 until 1989, Citizens Utilities had two classes of common stock

that differed only in their dividend policy: Series Astock paid a stock dividend (which is

not taxed) and series B stock paid a cash dividend (which generates personal income tax

liabilities for shareholders). The company’s charter required the stock dividend on series A

stock to be at leastof equal value to the cash dividend on series B stock. The stock divi-

dends were, on average, about 10 percent higher than the cash dividends.

In the absence of taxes, the two stocks should trade at an average price ratio compara-

ble to their dividend ratio. Taxable investors, however, would then prefer the series Astock

which pays no taxable dividend. This suggests that the price of series Astock should exceed

1.1 times the price of the series B stock because the untaxed stock dividend paid by the

series Astock is 10 percent higher than the taxed cash dividend paid by the series B stock.

As shown by Long (1978), the price of series Astock before 1976 was somewhat less than

1.1 times that of the series B stock, but in the period examined by Poterba (1986), 1976–84,

the ratio of the prices was about equal to 1.1. This evidence suggests that investors in Cit-

izens Utilities stock prices were not influenced by their personal tax considerations. Fur-

thermore, a study by Hubbard and Michaely (1997) showed that the relationship between

the prices of the two classes of Citizens Utilities stock was largely unaffected by the Tax

Reform Act of 1986 which substantially influenced the relative value of dividends and cap-

ital gains to taxable investors.¹¹

While dividends may have had no effect on Citizens Utilities stock prices, we cannot

generalize this finding to all firms. Since the two classes of Citizens’stock are essentially

the same, any large difference in their prices presents an opportunity for arbitrage by tax-

exempt investors. Indeed, the arbitrage argument described in Example 15.1 can be applied

to show that in the absence of transaction costs the stock prices must be identical. This

opportunity for arbitrage would not exist for other stocks, indicating that one might observe

two closely related, but not identical, stocks with different dividends providing very differ-

ent expected returns.