In their 1970 paper on dividends and taxes, Elton and Gruber reported that the exdividend– date drop in a stock’s price as a percentage of the dividend should equal the ratio of 1 minus the ordinary income tax rate to 1 minus the capital gains rate; that is,
Pe – pb/D =1 To/1 Tc
where
Pe _ The ex dividend stock price
Pb _ The stock price before it trades ex dividend
D _ The amount of the dividend
To _ The tax rate on ordinary income
Tc _ The effective tax rate on capital gains
Note: As we pointed out in the text, effective tax rate of capital gains is less than the actual tax rate, because their realization may be postponed. Indeed, because investors could postpone their realizations indefinitely, the effective rate could be zero.
a. If To = Tc = 0, how much will the stock’s price fall?
b. If To ≠ 0 and Tc = 0, how much will it fall?
c. Explain the results you found in (a) and (b).
d. Do the results of Elton and Gruber’s study imply that firms will maximize shareholder wealth by not paying dividends?