Reviewing the large body of works in Dividend Pricing - Free Essay Example

Sample details Pages: 13 Words: 3938 Downloads: 3 Date added: 2017/06/26 Category Finance Essay Type Analytical essay Did you like this example? For past 40 years, a large body of works on the ex-dividend day price behavior of stocks have demonstrated that the price drop in most cases is only partial, decreasing by less than the full dividend amount. Researchers have proposed three competing theories to explain this empirical preference for capital gains over dividends. These include the existence of tax-induced clienteles (Elton Gruber, 1970), short-term trading (Kalay, 1982) and discreteness of stock prices due to minimum tick-sizes (Bali Hite, 1998). Don’t waste time! Our writers will create an original "Reviewing the large body of works in Dividend Pricing" essay for you Create order Although the partial price drop is well established as an empirical regularity, the explanation of this behavior is still very much an unresolved issue. In this chapter, we will discuss these three competing theories in theoretical part and we will compare them critically. Then, in empirical part, we will go through the latest researches to show the research gap and construct research hypothesizes. 2.2 Theoretical Literature 2.2.1 Tax-Induced Clienteles Miller and Modigliani (1961) show that, in the context of perfect markets, with no taxation and no transaction costs, dividend policy is irrelevant. In this context, investors are indifferent between dividends or capital gains, and the price of the stock should go down by the full amount of the dividend on the ex-dividend day. (H. M. Miller Modigliani, 1961) Although Miller and Modigliani (1961) accept the existence of dividend clienteles, they argue that if the distribution of payout ratios corresponds exactly to the distribution of investor preferences, then the case is no different to the case of perfect markets, where it is irrelevant whether investors receive dividends or capital gains. Each firm will tend to attract its own clientele, consisting of investors that prefer its payout ratio. Black and Scholes (1974) propose that firms, knowing that there are preferences for differing types of dividend yields, will adjust their dividend policies as necessary to satisfy such de mand. Farrar and Selwyn (1967) observe that the unfavorable fiscal treatment of dividends over capital gains implies that firms should not pay dividends because investors would prefer the higher after tax returns associated with capital gains. Brennan (1970) develops this line of work and reaches similar conclusions. (Black Scholes, 1974) (Farrar Selwyn, 1967) (Brennan, 1970) Given the wide variety of investors present in markets, there is no doubt that there is differing preferences caused by any given fiscal framing. Several researches at that time tried to answer this question whether, by observation of real data, this clientele effect can be empirically detected. Elton and Gruber (1970) establish a relationship between stock price behavior on the ex-day and the tax levied on the marginal stockholder. In a market with rational arbitrage, the price drop should reflect the relative after-tax value of dividends and capital gains for the marginal stockholder. This implies that t he marginal investors income tax rate can be inferred simply by observing the price drop on the ex-day. The equilibrium condition is: Where is the stock price on the cum-dividend day, is the stock price on the ex-dividend day, is the stock price when bought, is the dividend, is the dividend tax rate and is the capital gains tax rate. From Eq. we obtain: Elton and Gruber (1970) find that, on average, the stock price drop is less than the dividend amount, which is consistent with the tax on dividends being higher than the tax on capital gains, in the period covered by their study. They also find a statistically significant positive relationship between the right hand side of Eq. , both with dividend yield and payout ratio. Barclay (1987) confirms the results of Elton and Gruber (1970), while Schlarbaum et al. (1978) find very little evidence of this type of relationship using individual investor data from a brokerage firm. After the 1986 tax reform act in the US that equalized t axes on dividends and capital gains, Michaely (1991) finds that the ex-day price drop remained below one contrary to the tax-induced clientele hypothesis. (Barclay, 1987) (Schlarbaum, Lewellen, Lease, 1978) (Roni Michaely, 1991) 2.2.2 Short Term Trading Around the Ex-Day Several papers study the effect of dynamic trading strategies around the ex-dividend day. These strategies imply that investors trade around the ex-dividend day in order to avoid or to capture the dividend, depending on their preferences for dividend or capital gain. Kalay (1982) shows that the price drop is bounded by transaction costs: Where, and is the expected cost of a round trip transaction. Only within the boundaries defined by transaction costs in Eq., where there are no arbitrage opportunities, would it be possible to infer tax-clienteles effect exists. Beyond those limits, the price drop would reflect only the effects of arbitrage trading. Miller and Scholes (1982) present a similar argument. (M. H. Miller Scholes, 1982) Eades et al. (1984) study the behavior of prices around the ex-dividend day and show the existence of abnormal returns on days other than the ex-day, which is contrary to the tax-induced clientele hypothesis. The results of Kalay (1982) are consist ent with the findings of Karpoff and Walking (1988), who detect a significant relationship between ex-day returns and transaction costs. Lakonishok and Vermaelen (1986) confirm the presence of short-term traders in the market around the ex-dividend day, detectable because of high or abnormal volumes. Michaely and Vila (1996) set out an inverse relation between transaction costs and abnormal volume. The evidence of abnormal volumes around the ex-day is contrary to the clientele models. Naranjo et al. (2000) re-examine and extend the work of Eades et al. (1984) and find that the high-yield stock ex-day returns were highly influenced by corporate dividend capture. (Eades, Hess, Kim, 1984) (Karpoff Walkling, 1988) (Lakonishok Vermaelen, 1986) (R. Michaely Vila, 1996) (Naranjo, Nimalendran, Ryngaert, 2000) 2.2.3 Market Microstructure Arguments The discreteness argument presented by Bali and Hite (1998) focuses on the multiple ticks of price changes as compared with the continuity of dividends. Because the price changes are discrete in most cases they cannot equal the dividend amount. The authors argue that the market systematically rounds the price drop down to the nearest tick and this causes the price to drop by less than the dividend amount. Dubofsky (1992) argues that an ex-dividend premium below one may be explained by mechanical rules imposed by the NYSE and AMEX for the ex-day adjustment of open limit orders to buy stock. (Dubofsky, 1992) The transition of ticks in US markets from 1/8 to 1/16 ticks and then to decimalization in 2001 provided an excellent opportunity to test the theory of Bali and Hite (1998). The reduction of ticks and the progressive elimination of discreteness should result in a price drop on the ex-day increasingly closer to one. Cloyd et al. (2006) refute the discrete pricing hypothesis and find new evidence consistent with long-term tax-induced clienteles. The price discreteness of Bali and Hite (1998) has been also refuted by Jakob and Ma (2004) and Graham et al. (2003). (Cloyd, Oliver Zhen, Connie, 2006) (Graham et al., 2003; Jakob Ma, 2004) 2.2.4 Comparison and conclusion Among these three theories that explained above, the microstructure theory is fully refuted. Because although after 2001 stock prices were decimalized, price drop ratio abnormality still exist in US market as Cloyd at al. (2006) proved. So, the price discreteness could not be a good explanatory reason. Short term trading theory also faced with several shortcomings. Transaction cost plays an important role to provide arbitrage opportunity. Therefore, this theory just can be apply for stocks which amount of dividend is high enough to compensate transaction cost and provide arbitrage opportunity on ex-date. In result, short term theory has its` own limitation and cannot generalize to all stocks and markets. Tax-clientele theory apparently is the first and more reliable theories while discussed first time by Miller and Modigliani (1961) on dividend area. Elton and Gruber (1970) extend this theory for the first time to explain price behavior on ex-date. Most of researchers confirm the result of Elton and Gruber (1970), while others only find very little evidence of this type of relationship. It is apparent that research methodology and sampling play an important rule to investigate tax-clientele theory. However, most of researchers find consistent results with Elton and Gruber (1970). Moreover, Withworth and Rao (2010) expand this research for a period of more than 80 years and find the same result. Moreover, they investigate the stability of this theory for two different period of time and approved the tax-clientele theory. In summary, we high light and confirm Borges (2008) point of views as follow: ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ different theories have not been very successful at explaining this regularity. At best, the evidence is still mixed as to the existence of tax-clienteles and, in most cases, is inconsistent with the discreteness hypothesis. By this deliberation, we select tax-clientele theory as our research framework and try to overco me its` shortcoming by introducing strategic ownership as a moderating variable. The reason behind it will be discussed in empirical literature review while we evaluate the latest researches critically. 2.3 Empirical Literature Review In this part we start with Elton and Gruber (1970) who founded Tax-Clientele theory on ex-dividend date pricing explanation. Then we review and criticize other related researches which tried to proved or refute this theory to show their difference and shortages. Consequently, we express how this research could fill these gaps and deficits and help the explanatory power of tax-clientele theory. As explained in theoretical literature, Elton and Gruber (1970) establish a relationship between stock price behavior on the ex-day and the tax levied on the marginal stockholder. In a market with rational arbitrage, the price drop should reflect the relative after-tax value of dividends and capital gains for the marginal stockholder. This implies that the marginal investors income tax rate can be inferred simply by observing the price drop on the ex-day. The equilibrium condition is: Where is the stock price on the cum-dividend day, is the stock price on the ex-dividend day, is the sto ck price when bought, is the dividend, is dividend tax rate and is the capital gain tax rate. From Eq. we obtain: Elton and Gruber (1970) hypothesize that high tax bracket investors will on average generally prefer to hold low dividend yielding stocks, to avoid the consequences of taxes, while low tax bracket investors will on average generally prefer to hold high dividend yielding stocks since taxes have a smaller impact on the after-tax value of dividend income. This theory is commonly referred to as the clientele effect. Empirically, Elton and Gruber (1970) document that on average, the securities of dividend paying stocks decline less than the amount of differential taxation on dividends and capital gains. Elton and Gruber (1970) also find that the implied tax bracket decreases when the dividend payout increases, which they interpret to imply that: (1) high tax bracket investors own low dividend yielding stocks; (2) low tax bracket investors own high dividend yielding stoc ks; and (3) corporations (who are taxed more on capital gains than they are on dividends), will prefer high dividend yielding securities. This, they argue, provides evidence of a tax-induced clientele effect. Eades, Hess and Kim (1984) investigate ex-dividend day returns of several taxable and non-taxable distributions by investigating the pricing behavior for five days on each side of the ex-dividend day which they define as the ex-dividend period. Their results are quite surprising and cast considerable doubt on the clientele or tax hypothesis interpretation of ex ­-day pricing behavior. Their paper contributes to the ex-dividend day literature by looking at four different dividend distributions. First, ex-dividend day returns for taxable cash distributions are observed to be positive and significant, which is consistent with the hypothesis that dividends are taxed more heavily than capital gains. Second, ex-dividend day returns for preferred stocks are negative and sign ificant; since corporations dividend tax rates are less than their capital gains tax rates, and they tend to be the largest clientele of preferred stock, one would expect a negative ex-day return as reported. Third, non-taxable stock dividends and splits are priced on the ex ­-day as if they are fully taxable. This result is puzzling, particularly if returns are caused by tax effects. In this case one would expect to find no ex-day premium for non-taxable distributions. Finally, non-taxable cash dividends are priced as if they receive a tax rebate. This result casts further doubt on the tax interpretation of ex-day pricing behavior. To help explain the conflicting results, Eades, Hess and Kim (1984) investigate several explanations of the ex-day period anomaly. In particular, they examine the possibility of errors in data, day of the week effects, dividend announcement effects, the impact of infrequent trading, and non-normality of returns. None of the proposed explanations a re capable of explaining the curious ex-dividend day results; however their research eliminates possible reasons for the documented ex- ­dividend day anomaly. Poterba (1986) also finds interesting results associated with the ex- ­dividend day when he examines the Citizens Utilities Co. Citizens Utilities is unique since it has one class of common stock which pays stock dividends and another which pays taxable cash distributions. Poterba (1986) finds that the cash dividends ex-day price decline is less than the dividend amount, while the price of the stock paying stock dividends declines on the ex-day by nearly the full amount of the dividend. Clearly the disparity between the ex-day dividend valuation and the observed prices of the two shares is consistent with previous explanations of dividend distributions Poterba (1986) offers the following explanations for his results, the first of which he himself admits may be weak. First, he argues, investors may value cash d ividend income more than stock dividends particularly when transaction costs are high. Second, he argues that investors may value certain firm attributes which are correlated with cash dividend payments. This may explain why firms pay cash dividends even though investors value cash dividends less than comparable capital gains. (Poterba, 1986) Barclay (1987) investigates the ex-day behavior of stock prices before income taxes exist. Looking at data between the years 1900 to 1910, Barclay finds that stock prices fell on average by the full amount of the dividend. This evidence is consistent with the hypothesis that investors value dividends and capital gains equally in the pre-tax period, and that the differential taxation of dividends and capital gains has since caused investors to discount the value of taxable cash dividends in relation to capital gains. Michaely (1991) tests for the validity of the tax-clientele effect and explicitly compares his findings to those of Elton an d Gruber (1970) and Kalay (1982). As a competing hypothesis, Michaely (1991) argues that the existence of short term traders and corporate traders dominates the market and thus affects the ex-dividend day return. In other words, he expects to find a premium greater than one on the ex-dividend day, whereas Elton and Gruber and Kalay (1982) find a premium less than and equal to one, respectively. Michaely (1991) terms his hypothesis the corporate-trading hypothesis. Michaelys analysis (1991) is unique in the sense that he identifies and eliminates two sources of heteroskedacity found in the premium, where the premium is defined as the ratio of the price change between the last cum-day and the ex-day to the amount of the dividend. When the premium is adjusted to correct for heteroskedacity, Miachaely (1991) finds a negative abnormal return, particularly among high yield securities. Since corporations may prefer dividends over capital gains, this result provides evidence that corpora te and short term trading on the ex-dividend day affect price behavior. In fact, Michaely (1991) finds no evidence of an adverse tax effect since he finds a negative premium. 2.3.1 Tax law Changes Although a complete understanding of the determinants of ex-dividend stock price behavior still eludes us, the essence of the best-known and most enduring of all theories is that different tax rates cause investors to value dividends and capital gains unequally. The works cited previously employ a wide variety of methodologies that have furthered our understanding, but there are few better opportunities to test theories about taxes than the natural experiment created by changes in a countrys tax laws. Therefore, the remainder of this subsection reviews most of the important works that have considered one or more tax law changes, whether in the U.S. or abroad. We then discuss some of their strengths and weaknesses, along with how this study advances knowledge in the area. We begin with Barclay (1987), who documents ex-day price behavior before and after the introduction of the Federal Income Tax in 1913. Using data from the Commercial and Financial Chronicle, Barclay finds that i s not only close to one but also stable across groups when stocks are sorted into quintiles by dividend yield. In a matched sample from the post-income tax era, is less than one and generally increases with dividend yield. These findings are clearly consistent with EG. While its uniqueness makes Barclays study (1987) extremely interesting, it does have one notable drawback. Specifically, his post-tax matched sample is drawn from the period 1962-1985. Although the Center for Research in Security Prices (CRSP) database makes it much easier to obtain these later prices, one cannot help but wonder how ex-day prices behaved immediately following 1913. Grammatikos (1989) examined ex-day price behavior before and after the Tax Reform Act (TRA) of 1984. The 1984 Act lengthened the time a corporation must hold the stock at risk from 16 to 46 days. If the corporation does not meet the minimum holding requirement, the dividend becomes ineligible for the inter-corporate dividend exclusion an d is instead taxed at the normal rate, thus eliminating the motivation for dividend capture altogether. Consistent with the added risk imposed on dividend capturers, ex-day returns rose on average after the Act, but not so much for stocks that could be hedged with options. (Grammatikos, 1989) Of all U.S. tax law changes, none has been more thoroughly researched with respect to its effect on ex-day pricing than the 1986 Tax Reform Act (TRA). The 1986 Act lowered ordinary personal and corporate income tax rates but eliminated preferential tax treatment of long-term capital gains. According to the EG model, either of these two changes should cause to rise (and ex-day returns to fall), and indeed most empirical investigations [e.g. Robin (1991), Lamdin and Hiemstra (1993), Koski (1996)] support this prediction. Probably the most notable dissenter is Michaely (1991), who finds that is not significantly different from one in any of the years 1986-1989 around the TRA, leading him to con clude that short-term traders are much more active now than in the time period studied by EG. (Koski, 1996; Lamdin Hiemstra, 1993; Robin, 1991) However, Bhardwaj and Brooks (1999) point out that Michaelys estimates may have been distorted by outliers. They are able to replicate his results, but after filtering out a small number of observations with other simultaneous distributions, excessively large positive or negative price drop ratios, and/or missing bid/ask prices on the cum- or ex-day, they find that in 1986 (i.e. before the TRA took effect) was on average less than one, positively correlated with the dividend yield, and negatively related to transaction costs, consistent with the integrated tax framework. (Bhardwaj Brooks, 1999) Ki (1994) results are mixed, as ex-day excess returns fall post-1986 for his NASDAQ sample but not for NYSE/AMEX securities. Finally, it is also worth pointing out that the 1986 TRA decreased tax heterogeneity, as it caused long-term investors and would-be arbitrageurs to view dividends and capital gains similarly. Michaely and Vila (1995) and Wu and Hsu (1996) support the general consensus that ex-day returns dropped following the 1986 reform, but consistent with prior arguments, they also find a significant reduction in ex-day volume as decreased heterogeneity reduced the incentive to trade. (Ki, 1994) (Roni Michaely Vila, 1995) (Wu Hsu, 1996) 2.3.2 Non-US Stock Markets Of course, studies of tax reforms need not be confined to the U.S. Tax law changes in the United Kingdom (UK) have provided several excellent opportunities to test the basic tax clientele model, and the evidence has been mostly supportive. While Poterba and Summers (1984) do not find a notable change in ex-day returns following the introduction of a capital gains tax in 1965, they do find a substantial drop following a 1973 reduction in the effective tax rate on dividends. Lasfer (1995) finds that ex-day returns decline following the 1988 Income and Corporation Taxes Act, which reduced the differential taxation of dividends and capital gains (similar to the 1986 TRA in the U.S.). (Poterba Summers, 1984) (Lasfer, 1995) Bell and Jenkinson (2002) study ex-day returns 30 months before and after the 1997 Finance Act (FA97), which removed pension funds preference for dividends over capital gains. Price drop ratios fell and ex-day returns rose following FA97, especially for high-yield stocks, implying not only that taxes affect valuation but also that pension funds are the likely marginal investors for the securities used in the study. (Bell Jenkinson, 2002) While the UK evidence has been mostly compatible with EG, results from Canadian tax reforms have been less so. In spite of a 1971 tax law change that increased the value of dividends relative to capital gains, Lakonishok and Vermaelen (1983) find lower price drop ratios for securities on the Toronto Stock Exchange, which they attribute to another provision of the tax reform that reduces short-term trader profits. In a sample period (1970-1980) covering four different tax regimes, Booth and Johnston (1984) find that is consistently less than one. However, they are unable to draw conclusions in favor of the tax model because PDR does not increase with dividend yield as hypothesized. (Lakonishok Vermaelen, 1983) (Booth Johnston, 1984) 2.3.3 Other Securities and Non-Taxable Distributions While most ex-day pricing research has focused on taxable cash dividends on common stocks, one can also make inferences about existing theories by observing the price behavior of different securities and around other distribution types. Eades, Hess, and Kim (1984) document negative excess returns for preferred dividends, as might be expected for high-yield dividend capture targets. However, Stickel (1991) obtains conflicting results. In his sample of nonconvertible preferreds, he finds positive abnormal returns and volume on the ex-day, with returns declining for more liquid stocks. So far, this is consistent with a synthesized model where both long-term investors and short-term arbitrageurs influence prices around preferred dividends. Inconsistent with this framework, however, is Stickels finding that trading volume increases with liquidity for low-yield but not high-yield preferred. (Stickel, 1991) Preferred dividends are of course relevant to ex-day pricing theories, but it i s perhaps more interesting to compare observations around non-taxable distributions against those around the usual taxable dividends. Eades, Hess, and Kim (1984) and Grinblatt, Masulis, and Titman (1984) examine ex-day price behavior around stock dividends and splits, which are non-taxable. According to both the EG model and the short-term trading hypothesis, these studies should find ex-day price drops fully reflective of the dilution caused by additional shares. In fact, neither does. Eades et al.(1984) report that non-taxable stock dividends and splits are priced on ex-dividend days as if they are fully taxable. Oddly, Grinblatt et al.(1984) note higher positive ex-day returns for stock dividends than splits, possibly due to the added inconvenience investors face when dealing with odd lots. (Grinblatt, Masulis, Titman, 1984) Green and Rydqvist (1999) study a unique security, Swedish lottery bonds, to which special rules apply. Coupon payments on the bonds (distributed by lott ery) are not subject to income tax, but capital gains are taxed at the ordinary rate. Furthermore, the regulatory environment is not conducive to short-term arbitrage using these securities. Consistent with the EG tax model, Green and Rydqvist find that the bond price drops by about 130 percent of the distribution on the ex-coupon day, and that the bonds frequently trade at negative pre-tax yields. (Green Rydqvist, 1999) Elton, Gruber, and Blake (2005) examine two samples of closed-end funds. In one sample, distributions are not taxed (but capital gains are); in the other, distributions are taxed normally. As expected, market-adjusted price drop ratios are greater than one for the non-taxable distributions but less than one for the taxable sample. Price drop ratios for both samples also behave as predicted by the EG model following tax law changes in 1993 and 1997. Similarly, Milonas, Travlos, Xiao, and Tan (2002) examine taxable and non-taxable dividends in the Chinese stock ma rket and find price behavior mostly consistent with the tax theory. (Elton, Gruber, Blake, 2005) (Milonas, Travlos, Xiao, Tan, 2006)