18.11 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,

where P_e  The ex-dividend stock price P_b  The stock price before it trades ex-dividend D The amount of the dividend T_o The tax rate on ordinary income T_c  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 not equal 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?

Transcribed Image Text:

P-Pb D 1-To 1- T