Dividend Policy and Clientele Rationality

This paper examines a firm's dividend and investment policies in a model in which some investors are not aware of some of the firm's investments. These naive investors attribute all dividend changes to earning changes, although the change in dividend is sometimes due to a new investment opportunity, beyond the firm's existing core business. For example, when a cost is incurred for such an investment and the dividend is consequently lowered, naive investors under-value the firm. The valuation of these investors influences prices since we assume all investors are risk averse. This implies that the firm will be under-priced when the investment cost is incurred. Following a similar argument, the firm is over-priced when the investment pays off. The model predicts that naive investors sell to sophisticated investors after a dividend decrease, and buy from sophisticated investors following a dividend increase. Generally, the firm's investment policy is suboptimal, typically involving under-investment. Surprisingly, having more naive investors sometimes brings the investment level closer to first best. Our model has several testable implications, in particular, the abnormal returns and trading patterns implied by naive investors' mispricing are supported by recent empirical studies.