Business: Dividend Decision


Dividend decisions play an important role in a company’s financial management because these strategies can have a significant impact upon the stakeholders’ preferences and their impact upon the company’s operations. Deciding between various patterns of sharing the company’s dividends between the stakeholders or reinvesting them into operations, decision-makers have to consider the personal preferences of stockholders which can depend upon their current financial situation.

The dividend decisions refer to the amount of payment received by shareholders and the timing of dividend distribution after the taxation of the company’s profit. The overall financial decision is made by taking into account the opinions of the company’s shareholders and evaluating the appropriateness of this decision for the post-tax profit of a particular company (Biswal 2007). In general, the choice of a proper dividend policy requires consideration of a great number of different and even conflicting factors.

Literature review

The clientele effect is connected with the level of taxation. On the one hand, the amount of dividends that can be paid out is determined after the taxation of the company’s profit. On the other hand, the received dividend as one of the sources of income influences the shareholders’ taxes. Elton and Gruber (1970) established the relationship between the amounts of dividend payments and shareholders’ taxes.

The results of their research have demonstrated a direct link between dividend decisions and the clientele effect within different companies. Explaining this relationship with the changes in the stock structure, the researchers put special emphasis upon the impact of shareholders’ personal opinions upon the company’s dividend decisions. Deciding on higher dividends, companies enhance their chances for attracting shareholders with different tax brackets (Borges 2002).

Campbell and Beranek (1955) explored the link between the changes in stock prices and the rates of shareholders’ taxes. Evaluating the impact of clientele effect upon the personal taxes of investors, the researchers explained the link with the differences in taxation of dividends and capital gains. The taxes on dividends have to be paid immediately while the taxes on capital gains can be paid later after the company’s stock is sold out. However, this taxation pattern is not favorable for companies that are accustomed to distributing the dividends among their investors shifting the burden of taxation to their dividend payment (Borges 2002).

Miller and Modigliani (1961) are known for their study of the influence of clientele effect on the dividend decisions of particular companies. The results of this study have demonstrated the close link between the shareholders’ expectations and companies’ dividend distribution patterns. Miller and Modigliani (1961) admitted that the dividend policy of a company plays an important role in attracting shareholders because of the correspondence between dividend rates and their personal preferences and expectations as to the time requested for regaining their initial investments.

Then, the clientele effect would allow investors to create their investment portfolios without paying more for using certain stock options. These investment portfolios will allow shareholders to make investments into various companies in the same sector at their discretion to increase the regains as soon as possible (Borges 2002).

Black and Scholes (1974) defined the clientele effect as the necessity to adjust dividend policies to the personal preferences of various groups of customers, depending upon their initial investments and expectations as to following opportunities of compensation or reinvesting. Determining clientele effect, Black and Scholes (1974) related it to the typology of investors. Reviewing various categories of potential shareholders and their corresponding expectations, the researchers distinguished between low dividend, medium dividend, and high dividend investors. They admitted that investors’ decisions depend upon the correspondence of their preferences and terms of the available investment options (Borges 2002).

Discussion and analysis

Theories of dividend policy relevance and irrelevance should be implemented by the company’s management for making the appropriate dividend decision as one of its most important financial decisions. The most important theories of dividend policy can be divided into two main groups dividend relevance and dividend irrelevance theories. The dividend clientele effect is one of the dividend irrelevance theories.

According to the dividend relevance theories, the dividend is defined as a variable affecting the market value of the firm, implying that the company’s management has to select the most appropriate dividend decision which would allow maximizing the value of the firm. The theories which were developed under this approach include traditional, Walter’s and Gordon’s Dividend Capitalisation models along with Bird-in-Hand and Dividend Signalling theories. The traditional model implies that there is a direct relationship between the firm’s market price and the number of dividends (Bierman 2010).

According to Walter’s model, the market price per share consists of dividends in the form of cash flows and the value of the company’s returned earnings. Regarding Gordon’s Capitalization model, it implies that the firm does not use external financing and is invested only through retained earnings, and consequently, its value depends upon the current dividends. Bird-in-hand theory was developed by Lintner and is based upon the assumption that shareholders give preference to receiving the dividends instead of relying on future capital gains because they are reluctant to take the associated risks (Schanz and Schanz 2011).

Dividend signaling theory treats the amount and dynamics of dividends as information signals to shareholders who can make certain conclusions concerning the current state of affairs and prospects of the company (Powell & Baker 2005). Thus, according to this theory, constant or increasing dividends can be regarded as a positive signal for shareholders, while their absence or decreasing dividend can be perceived as a negative signal causing the decline in market price.

The dividend irrelevance theories include Modigliani and Miller and rational Expectations models along with Residual and Dividend Clientele Effect theories. Models developed under this approach imply that dividends are irrelevant for determining the market value of the firm. According to residual theory, dividends are paid from residual only after the rest of the investments have already been made.

Regarding Modigliani and Miller’s model, it puts the main emphasis upon the firm’s investment policy which has the largest impact upon the market price of the share. Under the rational expectations model, the dividend policy does not affect the market price if it corresponds to the market expectations (Eckbo 2008). However, if the dividend is less than rational expectations, it can result in the decline of the market price.

As to the dividend clientele effect, as one of the dividend irrelevance theories, it is based on the assumption that dividend policy does not affect the firm’s value. Though the dividend decisions have a significant impact upon the investors’ behavior, different firms can choose different dividend policies by their internal circumstances (Pogue 2010). The company’s management can decide between higher and lower payout ratios at their discretion. However, the same goes for shareholders who may have various dividend preferences and make appropriate investment decisions by their current needs and circumstances.

Thus, some shareholders can prefer current dividends and make investments into the companies with generous dividend payouts, while others choose lower dividends, relying on future capital gains. The impact of the dividend ratio upon shareholders’ taxes is one of the reasons for shareholders to decide on companies that offer lower dividends. Taking into account the fact that shareholders will have to declare the received dividends as a part of their income, it can be stated that dividend policy will have an impact upon their taxes.

The impact on personal taxes is one of the reasons for which some shareholders prefer receiving small dividends or reinvesting them into the company’s operations if they do not need them for enhancing their consumption of goods and services (Biswal 2007). In other words, according to the clientele effect theory, a company’s management is free to make dividend decisions according to the firm’s internal needs because the shareholders’ dividend preferences vary and the firm will attract certain investors disregarding the dividend ratio of their choice.


This paper focused on various approaches to determining the relationship between the company’s dividend decisions and the corresponding changes in the firm’s market value if any. Reviewing the dividend relevance and the dividend irrelevance theories and models for establishing the links between the company’s dividend policy, investors’ behavior, and the market price of the company’s share, this study focused on clientele effect as one of the dividend irrelevance theories. Under clientele effect, shareholders’ dividend preferences vary due to their personal views and circumstances, allowing companies’ management to implement certain dividend strategies according to the firm’s internal needs.


Bierman, H., (2010) An introduction to accounting and managerial finance: a merger of equals. New Jersey: World Scientific Publishing.

Biswal, K.C., (2007) Corporate saving behavior. New Delhi, India: Northern Book Centre.

Borges, M.R., (2002) Fiscal effect in dividend distributions. Proceedings of XII Jornadas Luso Espanholas de Gestão Científica-Beira Interior University, Vol II-Finance, Covlhã.

Eckbo, B.E., (2008) Handbook of corporate finance: empirical corporate finance. Oxford, UK: Elsevier.

Pogue, M., (2010) Investment appraisal. New York: Business Expert Press.

Powell, G.E., and Baker, H.K., (2005) Understanding financial management: a practical guide. Oxford, UK: Blackwell Publishing.

Schanz, D., and Schanz, S., (2011) Business taxation and financial decisions. New York: Springer Heidelberg.

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