Academic journal article Quarterly Journal of Business and Economics

The Dividend Puzzle: A Progress Report

Academic journal article Quarterly Journal of Business and Economics

The Dividend Puzzle: A Progress Report

Article excerpt

The Dividend Puzzle: A Progress Report Steven V. Mann University of South California

Abstract

This paper reviews the major theoretical and empirical

contributions to the dividend literature since Black reported on

the state of knowledge in 1976. In these studies, two major

questions emerge that are critical to understanding the dividend

puzzle and justifiably receive the majority of the attention.

These questions are: 1. What are the tax effects of dividends;

and 2. What are the information effects of dividends? Recent

developments in dividend signalling models also are discussed.

Introduction

Black [7], in his article "The Dividend Puzzle," ends his discussion with two questions, "What should the individual investor do about dividends in his portfolios?" and "What should the corporation do about dividend policy?" His answer to both questions is a resounding "We don't know." While Black's response to these questions is still correct today, this answer does belie the fact that there is a great deal that has been learned about dividends in the last ten years.

The dividend puzzle does not exist in perfect capital markets. The pioneering work of Miller and Modigliani [49] demonstrates that the firm's dividend policy is irrelevant in perfect capital markets. Specifically, given a firm's operating policies, the dividend policy selected by the firm has no effect on the market value of the firm or the current wealth of the shareholders. Dividend policy is merely a vehicle to package the return of the firm's cash flows. This packaging has no effect on the common stock's market value. The key element of this argument is the separation of the firm's real and financial decisions.

Despite the many insights that can be derived from the examination of dividend policy in perfect capital markets, dividends seem to be important to both corporations and investors. The dividend puzzle arises when an attempt is made to reconcile the dividend irrelevance proposition with observed market behavior. In 1986, U.S. corporations paid $86.6 billion in dividends to their shareholders. Furthermore, investors react strongly to any changes in corporate dividend policy.

This paper provides a review of the major studies in the dividend literature since Black's report on the state of knowledge. In these studies, two major questions critical to the understanding of the dividend puzzle emerge and justifiably receive the majority of the attention. These questions are: 1. What are the tax effects of dividends; and 2. What are the information effects of dividends? These two questions are intertwined throughout the literature. Furthermore, Eades, Hess, and Kim [20] present evidence that these two effects may confound one another. Consequently, the primary focus of this paper is these two important pieces of the dividend puzzle.

The Tax Effect of Dividends

The question of the tax effect of dividends basically involves two related issues. First, do individuals in high (low) tax brackets concentrate their portfolios in low (high) yield securities as the result of the differential tax treatment of dividends and capital gains; i.e., the clientele effect?(2,3) Second, to what extent do tax factors influence the relationship between a firm's dividend yield and the market value of its equity? If the dividend yield affects value or return, it must be the case that investors prefer a certain yield, presumably due to their tax brackets. But even if investors prefer a certain yield and if their preferences are sufficiently heterogeneous, a supply effect may be observed. Firms will move to supply high priced dividend yields until an equilibrium is reached wherein all clienteles are satisfied (see Black and Scholes[9]). Recent studies examining each of these aspects of the tax effect will be reviewed. …

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