A Catering Theory of Dividends
*
Malcolm Baker
Harvard Business School and NBER
mbaker@hbs.edu
Jeffrey Wurgler
NYU Stern School of Business
jwurgler@stern.nyu.edu
November 7, 2002
Abstract
We develop a theory in which the decision to pay dividends is driven by investor demand.
Managers cater to investors by paying dividends when investors put a stock price premium on
payers and not paying when investors prefer nonpayers. To test this prediction, we construct four
time series measures of the investor demand for dividend payers. By each measure, nonpayers
initiate dividends when demand for payers is high. By some measures, payers omit dividends
when demand is low. Further analysis confirms that the results are better explained by the
catering theory than other theories of dividends.

On the Catering Theory of Dividends and the Linkage between
Investment, Financing and Dividend Policies


Gil Cohen
Emek Yezreel Academic College
E-mail: gilc@yvc.ac.il

Joseph Yagil
School of Management, Haifa University, Haifa, 31905, Israel
E-mail: yagil@gsb.haifa.ac.il
Tel: 972-4-8240085; Fax: 8249194


Abstract

This paper extends Baker and Wurgler’s(BW) “Catering Theory of Dividends”.
While the main issue addressed by their model is whether or not to pay dividends, the
extended model offered here, in contrast, incorporates other dividend related issues such as
the expected cash dividend and the dividend payout ratio. The extended model predicts a
negative relationship between the expected dividend per share and the ratio of information
about the cost of the dividend (C) held by“category” investors and “arbitrageurs”, the
percent of stock ownership held by “category” investors as well as the risk, tax and
investment premiums. The cost of the dividend (C) has been shown to include three types
of premiums- tax, risk and investment. The tax premium is due to the personal taxes paid
upon receiving dividends. The risk premium consists of two components. The first is the
increase in the financial leverage resultingfrom the dividend payment, and the second is the semi

contractual obligation of the dividend-paying firm to maintain the dividend
payment. The investment premium involvesthe opportunity cost associated with the
rejection of profitable investments in order to pay dividends. One implication of the
extended model is that the dividend sum depends on its short-term and long-term effect on
the stock price, and also depends on the financial leverage and investment opportunities.