Dividends and the Clientele Effect

Paper Summary:

This paper discusses the efficient market theory, the Modigliani-Miller (MM) cost of capital argument (and its relevance to dividend policy) and the clientele effect. Dividend policy and the clientele effect should properly be seen as specific topics within the broader realm of modern finance theory. The reason for this, quite simply, is that these concepts are best understood when placed within a more complete and general theoretical framework - and modern finance has provided just such a framework: the efficient market theory. This theory provides a comprehensive and unifying explanation of the workings of the market and by virtue of its stature, it affects virtually all aspects and interpretations of finance today. With this in mind, the departure point for this paper is an explanation of the theory of efficient markets. Then, having provided this "foundation," the two concepts of dividends and clientele effect are thoroughly analyzed and their validity more accurately judged. Only by placing these concepts within a larger theoretical framework can the reader appreciate all the implications which arise.

From the Paper:

"However, the authors of this theory acknowledge that this only applies in a perfect world, and here is where academic theory like the efficient market needs to be modified to reflect the real world. In reality there are a number of imperfections which could affect dividend policy and they can be roughly divided into three categories (Campbell and Gray). The first set can be grouped and labeled as those factors arguing against high divident payout. These include personal taxes (where "dividends are taxed, but capital gains are deferred"), transaction costs (which result from reinvesting the cash), as well as the particular firm's financing costs."

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