On SS8: Dividends and Share Repurchases: Analysis, there is a section on the dividend clientele effect. On the example (Dividend vs. capital gains), one of the questions ask us to compute the expected drop in share price when the stock goes ex-dividend.
Why do we need to take into consideration the tax on capital gains? Considering the dividend has already been announced, so the company has already made the decision to declare and pay dividends, shouldn`t the drop in price only be the after-tax dividend amount?
a) because dividends are taxed usually at a higher rate than capital gains.
so if the company pays dividends and the dividends are taxed at a higher rate - clientele may prefer that lower dividends be paid, and the funds be diverted back to the company - thus raising its stock price.
Combine this with the fact that older clients may prefer higher income in the form of dividends - given their lower tax rates, while a younger investor might prefer a stock price increase given that they would get taxed only if they sold their stock holdings later in the future.
read the section on clientele effect in the book - pretty well explained.
If someone bought a stock at Pb, sold it when the before the ex-dividend price (at Pw) -> his cash flow would be Pw - (Pw - Pb) TCg (he pays capital gains tax when he sold the stock).
If he sold it after the price declared a dividend D and then sold the stock at Px -> his cash flow is Px - (Px - Pb) TCg + D(1-Td)
equating the above two
Pw - Px = D * (1-Td) / (1-Tcg)
— and this seems to be the big equation in this section.
If the dividend are not taxed at all, then your equation becomes (1-0)/(1-Tcg). Drop in price will be greater than the dividend if the capital gain tax rate is lower than 1.