Refresher Reading
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2021 Curriculum CFA Program Level II Corporate Finance
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This reading covers the features and characteristics of dividends and share repurchasesas well as the theory and practice of corporate payout policy. A dividend is a distribution paid to shareholders. Dividends are declared (i.e., authorized)by a corporation’s board of directors, whose actions may require approval by shareholders(e.g., in most of Europe) or may not require such approval (e.g., in the United States).Shares trading ex-dividend refers to shares that no longer carry the right to the next dividend payment. Theex-dividend date is the first date that a share trades without (i.e., “ex”) this right to receivethe declared dividend for the period. All else holding constant, on the ex-dividenddate the share price can be expected to drop by the amount of the dividend. In contrastto the payment of interest and principal on a bond by its issuer, the payment of dividendsis discretionary rather than a legal obligation and may be limited in amount by legalstatutes and debt contract provisions. Dividend payments and interest payments inmany jurisdictions are subject to different tax treatment at both the corporate andpersonal levels.
In this reading, we focus on dividends on common shares (as opposed to preferred shares)paid by publicly traded companies. A company’s payout policy is the set of principles guiding cash dividends and the value of shares repurchasedin any given year. Payout policy (also called distribution policy) is more generalthan dividend policy because it reflects the fact that companies can return cash toshareholders by means of share repurchases and cash dividends. One of the longestrunning debates in corporate finance concerns the impact of a company’s payout policyon common shareholders’ wealth. Payout decisions, along with financing (capital structure)decisions, generally involve the board of directors and senior management and areclosely watched by investors and analysts.
Dividends and share repurchases concern analysts because, as distributions to shareholders,they affect investment returns and financial ratios. The contribution of dividendsto total return for stocks is formidable. For example, the total compound annual returnfor the S&P 500 Index with dividends reinvested from the beginning of 1926 to theend of 2018 was 10.0%, as compared with 5.9% on the basis of price alone. Similarly,from 1950 to 2018 the total compound annual return for the Nikkei 225 Index with dividendsreinvested was 11.1%, as compared with 8.0% on the basis of price alone. Dividendsalso may provide important information about future company performance and investmentreturns. Analysts should strive to become familiar with all investment-relevant aspectsof dividends and share repurchases.
This reading is organized as follows. Section 2 reviews the features and characteristicsof cash dividends, liquidating dividends, stock dividends, stock splits, and reversestock splits and describes their expected effect on shareholders’ wealth and a company’sfinancial ratios. Section 3 presents theories of the effects of dividend policy oncompany value. In Section 4, we discuss factors that affect dividend policy in practice.In Section 5, we cover three major types of dividend policies. Section 6 presentsshare repurchases, including their income statement and balance sheet effects andequivalence to cash dividends (under certain assumptions). Section 7 presents globaltrends in payout policy. Section 8 covers analysis of dividend safety. The readingconcludes with a summary.
Learning Outcomes
The member should be able to:
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describe the expected effect of regular cash dividends, extra dividends, liquidating dividends, stock dividends, stock splits, and reverse stock splits on shareholders’ wealth and a company’s financial ratios;
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compare theories of dividend policy and explain implications of each for share value given a description of a corporate dividend action;
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describe types of information (signals) that dividend initiations, increases, decreases, and omissions may convey;
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explain how agency costs may affect a company’s payout policy;
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explain factors that affect dividend policy in practice;
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calculate and interpret the effective tax rate on a given currency unit of corporate earnings under double taxation, dividend imputation, and split-rate tax systems;
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compare stable dividend with constant dividend payout ratio, and calculate the dividend under each policy;
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compare share repurchase methods;
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calculate and compare the effect of a share repurchase on earnings per share when 1) the repurchase is financed with the company’s surplus cash and 2) the company uses debt to finance the repurchase;
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calculate the effect of a share repurchase on book value per share;
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explain the choice between paying cash dividends and repurchasing shares;
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describe broad trends in corporate payout policies;
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calculate and interpret dividend coverage ratios based on 1) net income and 2) free cash flow;
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identify characteristics of companies that may not be able to sustain their cash dividend.
Summary
A company’s cash dividend payment and share repurchase policies constitute its payoutpolicy. Both entail the distribution of the company’s cash to its shareholders affectthe form in which shareholders receive the return on their investment. Among the pointsthis reading has made are the following:
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Dividends can take the form of regular or irregular cash payments, stock dividends, or stock splits. Only cash dividends are payments to shareholders. Stock dividends and splits merely carve equity into smaller pieces and do not create wealth for shareholders. Reverse stock splits usually occur after a stock has dropped to a very low price and do not affect shareholder wealth.
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Regular cash dividends—unlike irregular cash dividends, stock splits, and stock dividends—represent a commitment to pay cash to stockholders on a quarterly, semiannual, or annual basis.
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There are three general theories on investor preference for dividends. The first, MM, argues that given perfect markets dividend policy is irrelevant. The second, “bird in hand” theory, contends that investors value a dollar of dividends today more than uncertain capital gains in the future. The third theory argues that in countries in which dividends are taxed at higher rates than capital gains, taxable investors prefer that companies reinvest earnings in profitable growth opportunities or repurchase shares so they receive more of the return in the form of capital gains.
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An argument for dividend irrelevance given perfect markets is that corporate dividend policy is irrelevant because shareholders can create their preferred cash flow stream by selling the company’s shares (“homemade dividends”).
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Dividend declarations may provide information to current and prospective shareholders regarding management’s confidence in the prospects of the company. Initiating a dividend or increasing a dividend sends a positive signal, whereas cutting a dividend or omitting a dividend typically sends a negative signal. In addition, some institutional and individual shareholders see regular cash dividend payments as a measure of investment quality.
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Payment of dividends can help reduce the agency conflicts between managers and shareholders, but it also can worsen conflicts of interest between shareholders and debtholders.
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Empirically, several factors appear to influence dividend policy, including investment opportunities for the company, the volatility expected in its future earnings, financial flexibility, tax considerations, flotation costs, and contractual and legal restrictions.
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Under double taxation systems, dividends are taxed at both the corporate and shareholder level. Under tax imputation systems, a shareholder receives a tax credit on dividends for the tax paid on corporate profits. Under split-rate taxation systems, corporate profits are taxed at different rates depending on whether the profits are retained or paid out in dividends.
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Companies with outstanding debt often are restricted in the amount of dividends they can pay because of debt covenants and legal restrictions. Some institutions require that a company pay a dividend to be on their “approved” investment list. If a company funds capital expenditures by borrowing while paying earnings out in dividends, it will incur flotation costs on new debt issues.
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Using a stable dividend policy, a company tries to align its dividend growth rate to the company’s long-term earnings growth rate. Dividends may increase even in years when earnings decline, and dividends will increase at a lower rate than earnings in boom years.
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A stable dividend policy can be represented by a gradual adjustment process in which the expected dividend is equal to last year’s dividend per share plus [(Expected earnings × Target payout ratio − Previous dividend) × Adjustment factor].
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Using a constant dividend payout ratio policy, a company applies a target dividend payout ratio to current earnings; therefore, dividends are more volatile than with a stable dividend policy.
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Share repurchases, or buybacks, most often occur in the open market. Alternatively, tender offers occur at a fixed price or at a price range through a Dutch auction. Shareholders who do not tender increase their relative position in the company. Direct negotiations with major shareholders to get them to sell their positions are less common because they could destroy value for remaining stockholders.
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Share repurchases made with excess cash have the potential to increase earnings per share, whereas share repurchases made with borrowed funds can increase, decrease, or not affect earnings per share depending on the company’s after-tax borrowing rate and earnings yield.
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A share repurchase is equivalent to the payment of a cash dividend of equal amount in its effect on total shareholders’ wealth, all other things being equal.
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If the buyback market price per share is greater (less) than the book value per share, then the book value per share will decrease (increase).
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Companies can repurchase shares in lieu of increasing cash dividends. Share repurchases usually offer company management more flexibility than cash dividends by not establishing the expectation that a particular level of cash distribution will be maintained.
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Companies can pay regular cash dividends supplemented by share repurchases. In years of extraordinary increases in earnings, share repurchases can substitute for special cash dividends.
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On the one hand, share repurchases can signal that company officials think their shares are undervalued. On the other hand, share repurchases could send a negative signal that the company has few positive NPV opportunities.
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Analysts are interested in how safe a company’s dividend is, specifically whether the company’s earnings and, more importantly, its cash flow are sufficient to sustain the payment of the dividend.
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Early warning signs of whether a company can sustain its dividend include the dividend coverage ratio, the level of dividend yield, whether the company borrows to pay the dividend, and the company’s past dividend record.
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Corporate Finance
Dividend Policy
