CFA Level II Exam Review: Dividend Policy and Safety

Much of the Corporate Finance topic area is conceptual and the points can be picked up through a quick run through your study guide and a few times with summary sheets. We’ll review some of the ideas hear but don’t neglect the section completely. Get the concepts and basic formulas down and then spend the extra time on problem areas.
Types of Dividends and other Forms of Shareholder Returns
Dividends are usually paid out on a regular or special basis. Regular dividends fromU.S.companies are paid on a quarterly basis with the holder-of-record date two business days after the ex-dividend date. The ex-dividend date is the first day the shares trade without the dividend so anyone with the shares on the day before will receive the dividend on the payment date.
Special dividends, more often from cyclical companies experiencing a profit windfall, are rare and set by the board of directors. Liquidating dividends may be paid to shareholders when a company dissolves and is treated as a capital gain or loss for tax purposes.
There is some light material and formulas for stock dividends, where investors receive additional shares instead of a cash dividend. Cost basis per share is decreased (spread over the new number of shares) for tax purposes and debt/equity characteristics of the firm do not change.
Factors affecting Dividend Policy
The Institute does not spend a lot of time on taxes other than to say it depends on specific rates and the difference between imputation, split rate, and double taxation systems. You do not need to know the specific countries using different systems, just understand the basic difference between the three systems:

  • Double taxation: corporate earnings are taxed then taxed again at the shareholder level which may or may not lead investors to favor dividends depending on the difference between capital gains and dividend tax rates.
  • SplitRate: Earnings paid out as retained earnings are taxed differently than dividends which are then taxed at the individual level. This affects shareholder preference for dividends depending on their own individual tax rates.
  • Imputation: Dividends are only taxed at the shareholder level through a credit for corporate taxes paid.

Float costs on equity affect policy but the material only covers it briefly in that as float costs increase firms will use more retained earnings (and issue fewer dividends) for capex rather than issuing more stock.
Dividend restrictions- debt or regulatory requirements may prohibit dividend payments. The capital impairment rule is the most often cited, that the company cannot cause retained earnings to become negative by issuing dividends.
Clientele effect- Some investors, depending on tax rates and income needs, prefer dividends so are drawn to dividend payers. The curriculum addresses this later in the point that, again depending on taxation, investors could effectively create a dividend by selling shares anyway so the argument for the clientele effect is somewhat weak.
Make sure you understand the idea behind information content of dividends (signaling effect). That increasing dividends could signal a lack of investment opportunities or that management perceives stability/adequacy in future earnings. Conversely, a decrease in dividends could signal lack of sufficient capital or reliability of future earnings. The concept is the impetus behind conservative dividend payout practices to avoid volatility in payments.
The firm can set its dividend policy by: residual, long-term residual, stable dividend, or the target payout approach. Be sure to understand the concept behind the first three but be able to calculate the target payout approach. In the Target Payout, the expected dividend increase will be the expected increase in earnings times the target payout ratio times an adjustment factor. The adjustment factor helps to reduce volatility in the dividend and allows for an incremental move towards a target payout ratio. The adjustment factor also allows dividends to increase even with a decrease in earnings but will also cause the dividend to increase less in strong years.
The dividend ‘theories’ seem a little academic. Again,  just understand the basic idea behind dividend irrelevance, bird-in-the-hand, and tax aversion.
Three Measures of Dividend Safety
Three basic measures of dividend safety are given and candidates should be able to use the formulas.
Dividend Payout Ratio is just the dividend amount divided by net income. A higher ratio (more net income paid out) is obviously more risky because less is retained and available. If the company has increased capital needs, then the dividend will need to be cut.
Dividend coverage Ratio is the inverse of the payout ratio (net income divided by dividends) so really says the same thing but with a lower ratio being more risky.
Free Cash Flow to Equity (FCFE) Coverage Ratio is FCFE divided by the amount of dividends and share repurchases. Remember FCFE is the available cash for equity holders after necessary fixed investment and borrowing to keep the company a going concern. See the previous post on how to calculate FCFE. If the company is returning all available cash as dividends or share repos, then the ratio is one. If the ratio is less than one, the company is paying out more in dividends/share repos than is available and will eventually need to issue more equity.
As with a lot of the sections within the Corporate Finance topic area, the dividend material is fairly conceptual with some basic formulas. It should be easy points that you can get by going over your study guide or just a summary sheet a few times. Get the concepts down and spend the rest of your time on the more intense sections like FRA and Equity.
Friday, we’ll review some of the best resources and ways to find a little extra time as you get close to the exam.
‘til next time, happy studyin’
Joseph Hogue, CFA

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