Describe dividend decisions

Reference no: EM1316098

Describe Dividend decisions

Elton and Gruber (1970) test for the existence of dividend clienteles by measuring the average decline in stock price when the stock goes ex-dividend. The model they test is:

(P_B - P_A) / D = (l - ζ₀) / l - ζ_g , where:
PB = stock price before the dividend,
PA = stock price after the dividend,
D = the cash dividend,
τo = the tax rate on dividend income,
τg = the tax rate on capital gains income (assume τg = 0.5* τo).

a) What conclusions do Elton and Gruber reach concerning the existence of dividend clienteles?

b) How would the presence of arbitrageurs (who buy or sell stock just before the exdividend date, and close their positions right after the ex-date) affect the conclusions drawn by Elton and Gruber? Explain in the context of the model presented above. Hint: consider the tax treatment of the arbitrage trades for individuals with differential tax rates (i.e., ordinary income tax rate ≠ cap gains tax rate) and for institutions with little or no direct tax exposure (endowments and mutual funds).

Reference no: EM1316098

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