Dividends and Capital Asset Prices

Tax based dividend models of capital asset pricing assume that dividends are known at the time prices are set. Dividends which are announced and paid in the same month, and dividends which were expected but cancelled in the month constitute surprises which interfere with many empirical tests of the effects of expected dividend yield on returns. This paper avoids these problems by relating returns to forecasts of dividend yield obtained from past data. THREE DISTINCT VIEWS OF the importance of dividends to investors have received support at one time or another. According to the two most important views, dividends have a neutral and a negative effect on security prices respectively. Miller and Modigliani [1] and Miller and Scholes [12, 13] favor complete substitutability of dividends and capital gain. Brennan [6] and Litzenberger and Ramaswamy [9] have developed models which incorporate differential taxation of income and capital gain. In these models, the tax disadvantage of income changes the investor's portfolio problem from one of optimization of mean and variance of portfolio before-tax return to optimization in after-tax terms. Stocks with relatively large dividend yields should provide high expected returns (and so sell for low prices) to compensate the investor for the tax. Much of the empirical evidence seems to favor the view that tax disadvantages of dividend income do not escape investors' attention and that returns are higher when they include dividend income to compensate the investor for the tax liability. However, interpretation of the available evidence is difficult and it is significant that most of these researchers remain unconvinced that their own findings can be satisfactorily explained by tax effects. Ball, Brown, Finn, and Officer [1] interpret their estimates as being far too strong to be explained in terms of differential taxation. Blume [3] reaches a similar conclusion, but Litzenberger and Ramaswamy attribute their results to the tax disadvantage of