- CFA Exams
- 2023 Level II
- Topic 4. Corporate Issuers
- Learning Module 18. Analysis of Dividends and Share Repurchases
- Subject 4. Factors Affecting Dividend Policy
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Subject 4. Factors Affecting Dividend Policy PDF Download
A company with many profitable investment opportunities will tend to pay out less dividends than a company with fewer opportunities.
The Expected Volatility of Future Earnings
The nature of business has an important bearing on the dividend policy. Industrial units having stability of earnings may formulate a more consistent dividend policy than those having an uneven flow of incomes because they can predict easily their savings and earnings.
Well established and large firms have better access to the capital market than the new companies and may borrow funds from the external sources if there arises any need. Such companies may have a better dividend pay-out ratio. Whereas smaller firms have to depend on their internal sources and therefore they will have to build up good reserves by reducing the dividend payout ratio for meeting any obligation requiring heavy funds.
Governments use the taxation of dividends to address different goals: either to encourage or discourage the retention or distribution of corporate earnings; to redistribute income; or to address other political, social, and/or investment goals. Most developed markets tax shareholder investment income: some tax both capital gains and dividend income, some tax only one of them, and some (e.g., Hong Kong) levy no tax on either dividends or capital gains.
- Double taxation.
- Split rate.
- Imputation tax system.
What do investors prefer, dividends or capital gains? The trade-off between taxes on dividends and taxes on capital gains is an important part of the equation. Even if dividends were to be taxed at a lower rate than capital gains, it's still not clear that shareholders would necessarily prefer higher dividends.
- Capital gains taxes are not paid until the stock is sold, and thus have a lower effective tax rate due to time value effects.
- If a stock is held by someone till death, no capital gains tax is due when the beneficiary receives the stock.
- Tax-exempt institutions such as pension funds and endowment funds are indifferent as to whether their return comes in the form of current dividends or capital gains.
The fact that it costs us something to issue or "float" a new issue needs to be taken into account (e.g., a person has to pay Merrill Lynch to sell the issue on his or her behalf, plus lawyers and accountants).
For newly issued common stock: re = D1 / P0 (1 - F), where F is the percentage flotation cost incurred in selling the new stock so P0 (1 - F) is the net price per share received by the company. However, for existing retained earnings, accumulated from profits, there is no floatation cost.
Dollars raised by selling new stock must "work harder" than dollars raised by retained earnings (re, the cost of new equity capital, is always greater than rr, the cost of retained earnings). Therefore, instead of paying dividends, firms with good investment opportunities typically want to utilize retained earnings as much as possible.
Contractual and Legal Restrictions
- Legal restrictions. Except in a liquidation, companies can't pay dividends out of initial contributed capital, - must be out of accumulated earnings.
- Restrictions from debt covenants. Certain minimum figures are such for such constraints as interest coverage, current ratio, and net worth, before any dividend payments may be considered.
- Informal restrictions. Some companies may continue to pay a regular scheduled dividend even when earnings are down and even less than their dividend payments.
- Implicit restrictions. For example, a rapidly growing company may not want to issue a dividend because shareholders could interpret a dividend as a lack of investment opportunities for the company. Banks, on the other hand, typically have a dividend yield that exceeds that of the overall market.
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