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The Clientele Effect Of Dividend Policy


Corporations are the only shareholders with a tax preference for cash dividends. This has led to predictions that corporations will invest in high dividend-paying stocks and use their voting power to increase dividends but in contrast to these predictions, dividends do not increase following trades of large-percentage blocks of stock from individuals to corporations and a lower tax rate does not necessarily mean that a higher dividend is desirable. This problem brings the problem experts like referring to as the clientele’s effect.

The clientele effect indicates that investors will tend to hold only those stocks whose dividend policy seems to fit their needs, that is, the investors preferring some forms of present gains over uncertain future earnings. Most investors thus tend to hold more of the stocks with high pay out compared to those with low pay out.

A dividend policy refers to the decisions a company makes for its investors regarding the magnitude of the dividend payout or the percentage of earnings paid to an investor in the form of dividends (Azzopardi 2004). Others refer to the dividend policy as “the practice that management follows in making dividend payout decisions or, in other words, the size and pattern of cash distributions over time to shareholders” (Lease Kose et al.2000:2).

Whatever rate the company will decide to pay its shareholders is clearly stipulated in this policy. Whereas some argue that companies should give high dividend, others argue against it because when investors were joining the company, they knew the company policy concerning dividends. Thus much of the literature has been about the relevancy and the irrelevancy of dividends policy.

Literature Review

In testing the theory of tax clienteles for dividend policies, researchers have been unable to indicate that the effects of tax clienteles for dividend policies are strong enough to influence the decisions of investors. For example, some writers argue that shareholder clienteles do not change much in response to dividend changes (Azzopardi 2004). They relate this assumption to the trading frictions, loss of diversification and voting power that results from selling shares thus no matter how insensitive the dividend policy might be to the investor, the likelihood of the shareholder changing his or her decision is hard.

In the same line of argument, Miller and Modigliani (1961) showed that in a tax free world of perfect capital markets in which investment was held constant, a firm’s policy is not relevant to its shareholders. Introduction of taxes in the model of Miller and Modigliani implies that in the absence of non tax factors, tax clienteles for different policies will still exist. For example, the investors whom dividends are taxed at lower rates than capital gains will prefer receiving equity returns as dividends while those investors whom dividends are taxed at higher rates will prefer to receive equity returns as capital gains and another group might be indifferent between either receiving equity returns as capital gains or dividends (Baker 2009).

It is important to note that dividend decisions are usually taken with market expectations in the mind and most of companies maintain dividend no matter how low their profits are in order to keep their investors and thus dividends are relevant to investors. What could happen if the investors do not like the dividend policy chosen by the management? If such a case existed in a perfect market, there would be no costs since there are usually no costs of buying or selling or costs of entry and exit. The investors could simply sell their securities when the dividends received do not satisfy their current needs for income

The clientele effect will thus occur when a firm draws a given clientele based on a dividend policy. However, unless there is a greater aggregate demand for a particular policy than is being satisfied in the market, dividend policy is still unimportant. The clientele effect only tells us to avoid making capricious changes in a company’s dividend policy (Correia al. 2004). An increase in the dividend is most of the times accompanied by an increase in the stock price while a dividend cut leads to a decline in the stock prices. This is one of the observations which have been made to refute the irrelevance theory and the critics of the dividend policy (Brigham & Houston 2009).

Al-Malkawi, Rafferty and Pillai (2010) suggest that clienteles tend to be attracted to investing in dividend paying stocks because they tend to have tax advantages. With most of the investors being interested in after tax returns, the different dividend policies influence their preference of dividends over capital gains thus if a policy is favoring exemption or reduced taxes, many investors will be attracted to the policy.

In addition, if the dividends offered are larger than what the expectations of the investor were, this could result in the investor purchasing excess stock. However, if the assumption of a perfect market is done away with, the buying and selling of the stocks is not cost free as transaction costs would arise. Brokerage fees are incurred and the investor who buys the stock with cash received from the dividends pays taxes before reinvesting the cash and this is an extra cost incurred. Still in this case, bearing the fact that when the stock is bought it has to be re-evaluated, acquisition for the information thus is time consuming and very costly to the investor.

.As a result of these considerations, investors may thus not be too inclined to buy stocks that require them to create a demand stream more suitable to their purposes (Keown, Martin, Petty, & Scott 2003). Thus it is important to note that both investors and managers show much appreciation to the role a dividend policy plays

Analysis and Discussion

The analysis of the clientele effect of the dividend is usually associated to market imperfections and taxes existence. The purpose of this study is to analyze the clientele effect of dividend policy and its relevance to shareholder tax situation. That is, if the different fiscal treatment of dividends make the investors prefer stocks of higher or smaller dividend yields or capital gains.

According to the Modigliani and Miller theory, the conditions they are giving about the irrelevance of the dividends are not real since as everybody knows, there are no perfect markets where entry and exit is free, a market without taxes as well as information asymmetry.

Though some experts admit to the clientele effects associated to dividend distributions, they usually state that if the distribution of the firm’s payout corresponds to the distribution of investors’ preference, then the situation cannot be classified as different from a perfect market case where it is usually irrelevant for the investors to receive dividends. Each firm will thus tend to attract its own clientele constituted by the investors who prefer pay out ration.

The possibility of the existence of a clientele effect can also be felt when firms knowing that there exists different investors for the different types of dividend yields, adjust the dividend policy to satisfy the demand of the company or the firm. In this situation, some investors might prefer the high yielding dividends while others would prefer the low yielding dividends. The group that prefers the high yielding dividend does so because it supports high taxes on capital gains than on dividends in contrast to the second group which includes all those investors who pay higher taxes on dividends than on capital gains.

Sometimes, even if the income tax of individuals is higher than the tax on capital gains, instruments do exist which allow the individuals to design investment and financing strategies in order to neutralize the disadvantage of the dividends. If the investors were to be described as indifferent to dividends or capital gains there could be no reason to detect any clientele effect associated to the differential fiscal and the irrelevance of the dividend policy could then be argued out.

The consequences of the clientele effect are that it suggests firms get the investors they deserve because the dividend policy attracts investor who likes the policy itself. While in the short run this is a positive decision, it also means firms will in future have a difficulty in changing an already established dividend policy even if the change makes sense because the consumers do not prefer the changes.

Finally, it is worthy noting that the clientele effect also provides an alternative argument to irrelevance of dividend policy at least when it comes to valuation. Thus if investors migrated to a firm or a company that pays dividends that most closely match their needs, no firm’s value could be affected by its dividend policy. Thus, a firm that pays low or no dividends should not be penalized for doing so because its investors do not want dividends like wise a company that pays high dividends should not have a lower stock value because those investors who have invested with the company prefer high dividends to future capital gains. We can, therefore, argue there are enough investors in each dividend clientele and this allows firms to be fairly valued no matter what their dividend policy is (Damodaran 2010).


According to the theory of Miller and Modigliani, dividends policy is irrelevant of the company value however in reality it is important to know that the clientele effect on a dividend policy exists and whether a policy decides to offer a high or low dividend value should not alter the stock values of an organization. Due to the clientele effect, an investor can chose to invest in a high value dividend policy or allow dividend policy depending on the tax incentives which follow.

Reference List

Al-Malkawi, N, H. A; Rafferty, M; Pillai, R. 2010. Dividend Policy: A Review of Theories and Empirical Evidence. Web.

Azzopardi, F. 2004. Dividend irrelevance and the clientele effect: University of Leicester. Web.

Baker, H. K. 2009. Dividends and Dividend Policy. New York, John Wiley and Sons Publishers.

Brigham, E. F; & Houston, J, F. 2009. Fundamentals of Financial Management. London, Cengage Learning.

Correia, L., Silva, D,.Marc Goergen, M., & Rennebo, L. 2004. Dividend policy and corporate governance. Oxford, Oxford University Press.

Damodaran, A. 2010. Applied Corporate Finance. 3rd Edition. New York, John Wiley and Sons.

Keown A, J; Martin, D, J; Petty, W; Scott, D. 2003. Foundations of finance: the logic and practice of financial management. London, Pearson Education Asia Limited & Tsinghua University Press.

Lease, R. C: Kose, J; Avner, K, Uri L: Oded, H. S, 2000. Dividend Policy: It’s Impact on Firm Value. Boston Massachusetts, Harvard Business School Press.

Miller, M. H; Modigliani, F. 1961. Dividend Policy, Growth and the Valuation of Shares. Journal of Business, 34, 411-33.

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