A Catering Explanation for Dividends: A Behavioral Perspective

In conventional corporate finance, firms trade off the costs of paying dividends (the differential tax costs to their investors, the issuance costs of new financing) against the benefits of dividends (signaling benefits and reduced agency costs) to determine whether they should pay dividends. Baker and Wurgler offer an alternative explanation where firms cater to the investor desire for dividends. Looking at the time period between 1963 and 2000, they use the difference between the market to book ratios of dividend payers and dividend non-payers as a measure of investor demand for dividends; when investors, in the aggregate, like dividends, dividend payers trade at a premium over non- payers, and when investors do not want dividends, dividend payers trade at a discount. They find that the dividends paid by firms can be better explained by investor demand for dividends, with more firms paying dividends when dividend payers trade at a premium, and fewer firms paying dividends when dividend payers trade at a discount.

The catering rationale for dividends is more an explanation for how firms set dividends in the aggregate and less about dividend policy in individual firms, but it does point to an important. Investor preferences for dividends shift over time and firms have to respond to changes in these preferences. Managers, when setting dividend policy, have to be aware not only of what investors, in the aggregate, think about dividends but also of what investors in their firm think about dividends. It would seem to use that the catering explanation is a dynamic version of the clientele story, where the preferences for dividends on the part of investors in a firm can change over time, and dividend policy has to change with it.