Discuss the effects on distribution policy consistent with: (1) the signaling hypothesis (also called the information content hypothesis) and (2) the clientele effect

Answer:

1. Signaling hypothesis:

It has long been recognized that the announcement of a dividend increase often results in an increase in the stock price, while an announcement of a dividend cut typically causes the stock price to fall. One could argue that this observation supports the premise that investors prefer dividends to capital gains. However, MM argued that dividend announcements are signals through which management conveys information to investors. Information asymmetries exist—managers know more about their firms’ prospects than do investors. Further, managers tend to raise dividends only when they believe that future earnings can comfortably support a higher dividend level, and they cut dividends only as a last resort. Therefore, (1) a larger-than-normal dividend increase “signals” that management believes the future is bright, (2) a smaller-than-expected increase, or a dividend cut, is a negative signal, and (3) if dividends are increased by a “normal” amount, this is a neutral signal.

2. The clientele effect:

Different groups, or clienteles, of stockholders prefer different dividend payout policies. For example, many retirees, pension funds, and university endowment funds are in a low (or zero) tax bracket, and they have a need for current cash income. Therefore, this group of stockholders might prefer high-payout stocks. These investors could, of course, sell some of their stock, but this would be inconvenient, transactions costs would be incurred, and the sale might have to be made in a down market. Conversely, investors in their peak earnings years who are in high-tax brackets and who have no need for current cash income should prefer low-payout stocks.

Clienteles do exist, but the real question is whether there are more members of one clientele than another, which would affect what a change in its dividend policy would do to the demand for the firm’s stock. There are also costs (taxes and brokerage) to stockholders who would be forced to switch from one stock to another if a firm changes its dividend policy. Therefore, we cannot say whether a dividend policy change to appeal to one particular clientele or another would lower or raise a firm’s cost of equity. MM argued that one clientele is as good as another, so in their view the existence of clienteles does not imply that one dividend policy is better than another. Still, no one has offered convincing proof that firms can disregard clientele effects. We know that stockholder shifts will occur if dividend policy is changed, and since such shifts result in transactions costs and capital gains taxes, dividend policy changes should not be taken lightly. Further, dividend policy should be changed slowly, rather than abruptly, in order to give stockholders time to adjust.