problem: Elton and Future (1970) test for the existence of dividend clienteles by measuring the average decline in stock value when the stock goes ex-dividend. The model they test is:

(PB - PA) / D = (l - ζ0) / l - ζg, where:

PB = stock value before the dividend,

PA = stock value after the dividend,

D = the cash dividend,

τo = the tax rate on dividend income,

τg = the tax rate on capital gains income (assume τg = 0.5* τo).

[A] What conclusions do Elton and Future reach concerning the existence of dividend clienteles?

[B] How would the presence of arbitrageurs [who purchase or sell stock just before the ex-dividend date, & close their positions right after the ex-date] affect the conclusions drawn by Elton & Future? Describe in the context of the model presented above. Suggestion: consider the tax treatment of the arbitrage trades for individuals with differential tax rates [i.e., ordinary income tax rate ≠ cap gains tax price] & for institutions with little or no direct tax exposure [endowments and mutual funds].