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,

a. If T_o = T_c = 0, how much will the stock’s price fall?

b. If T_o ≠ 0 and T_c = 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 1-T D -T where P = The ex-dividend stock price == P = The stock price before it trades ex-dividend D=The amount of the dividend T The tax rate on ordinary income 0 T = The effective tax rate on capital gains