Learning Outcomes
After reading this article, you will be able to compare the main theories of dividend policy, analyze the effects of share repurchases, and explain how dividend and repurchase decisions can signal management’s outlook. You will understand the practical implications for valuation, investor perceptions, and exam-relevant calculations for changes to capital structure and payout policy.
CFA Level 2 Syllabus
For CFA Level 2, you are required to understand how payout policy and capital structure decisions influence firm value, investor signals, and market price. You should focus your revision on:
- Defining and distinguishing between regular, special, and liquidating dividends
- Comparing stable dividend, constant payout, and residual dividend policies
- Explaining dividend irrelevance, bird-in-hand, and tax preference theories
- Analyzing share repurchase methods and their effects on financial metrics
- Interpreting dividend and repurchase actions as signals to the market
- Calculating the impact of payout decisions on earnings per share (EPS), book value per share (BVPS), and coverage ratios
- Evaluating dividend sustainability and factors that influence payout policies
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Which theory suggests investors are indifferent to whether returns come from dividends or price appreciation in a world with no taxes or transaction costs?
- If a company repurchases shares with excess cash, what is the likely impact on earnings per share (EPS), ignoring taxes and changes to net income?
- True or false? An unexpected increase in regular dividends is generally interpreted by the market as a positive signal regarding management’s expectations.
- List one advantage and one disadvantage of paying high regular cash dividends.
Introduction
Capital structure and payout policy decisions shape how a company returns value to shareholders and send signals to the market. Payout policy covers not only cash dividends (both regular and irregular) but also share repurchases, as companies increasingly use buybacks alongside dividends. Understanding the theories and practical effects of these decisions is essential for both valuation and interpreting signals for the CFA Level 2 exam.
Key Term: payout policy
The firm’s approach to distributing earnings to shareholders through cash dividends, special dividends, share repurchases (buybacks), or a combination.
TYPES OF DIVIDENDS AND PAYOUT METHODS
Companies can return cash to shareholders through several methods: regular cash dividends, special (or extra) dividends, liquidating dividends, stock dividends, and share repurchases.
Key Term: regular cash dividend
A recurring payment to shareholders, usually quarterly or annually, representing a portion of earnings.Key Term: share repurchase
When a company buys back its own shares from the market, reducing the number of shares outstanding and returning cash to shareholders.
Regular cash dividends communicate stable, ongoing profitability, while special and liquidating dividends typically signal one-time, non-recurring returns. Stock dividends (issuing additional shares) impact the number of shares owned but not the proportionate ownership or value.
Share repurchases are an alternative payout method, favored for their flexibility and, in some jurisdictions, tax advantages.
THEORIES OF DIVIDEND POLICY
Dividend policy has been extensively studied. Three primary theories are tested at Level 2:
- Dividend Irrelevance Theory: Proposed by Modigliani and Miller, this theory states that, in perfect markets with no taxes or transaction costs, dividend policy does not affect the firm’s value. Investors can create their own desired dividend stream by buying or selling shares as needed.
Key Term: dividend irrelevance theory
The proposition that, with no market imperfections, a firm’s value is unaffected by its dividend payout policy.
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Bird-in-the-Hand (Dividend Preference) Theory: Suggests that investors value certain cash dividends more highly than uncertain future capital gains, so a higher payout is viewed as less risky and increases firm value.
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Tax Preference Theory: Argues that, because dividends may be taxed more heavily than capital gains, some investors prefer firms that retain earnings or repurchase shares rather than pay high dividends.
SIGNALING EFFECTS OF DIVIDEND AND REPURCHASE DECISIONS
Management’s payout decisions convey information about profitability and future prospects, especially when information asymmetry exists.
Key Term: signaling
The concept that corporate actions (like dividend changes or share repurchases) communicate information about management’s private assessment of the firm's future.
An unexpected increase in dividends is often interpreted by the market as management’s confidence in sustainable future earnings. Conversely, a dividend cut or omission typically signals expected financial weakness.
Share repurchases can also signal that management believes the firm’s shares are undervalued.
Worked Example 1.1
A company has paid a stable dividend of $1.00 per share for five years. This year, it announces an increase to $1.30 per share. What signal does this send, and what might you expect for the share price if investors believe management has private information about future earnings?
Answer:
The dividend increase signals that management expects higher or more stable earnings going forward. If the market trusts management’s assessment, the share price is likely to rise in response to the perceived improvement in outlook.
SHARE REPURCHASES: METHODS AND EFFECTS
Common methods of share repurchase include:
- Open-market repurchases (most flexible and common)
- Fixed-price tender offers
- Dutch auction tenders
- Direct negotiation (e.g., with large shareholders)
Share repurchases reduce shares outstanding and may increase metrics like EPS and return on equity (ROE), even if total earnings remain unchanged.
Key Term: EPS (Earnings per Share)
A measure of profit allocated to each outstanding share, calculated as net income divided by the number of shares outstanding.Key Term: dividend coverage ratio
A measure of the sustainability of dividends, typically net income divided by total dividends (or by dividends plus repurchases for total payout coverage).
Worked Example 1.2
ABC Corp. has net income of $10 million, 5 million shares outstanding, and declares a $2 million dividend. What is the dividend coverage ratio?
Answer:
Dividend coverage ratio = Net income / Total dividends = $10 million / $2 million = 5. This means ABC can pay its dividend five times from current earnings; generally, a higher ratio suggests the dividend is more sustainable.
CHOOSING BETWEEN DIVIDENDS AND REPURCHASES
Firms may prefer buybacks to regular dividends for flexibility, possible tax benefits, and to offset dilution from share-based compensation. However, sustained, high buybacks may signal insufficient profitable investment opportunities.
Payout policy choice depends on:
- The firm’s investment opportunities and cash needs
- Management’s signaling intentions
- Tax considerations for investors
- Current share price valuation
IMPACT ON FINANCIAL METRICS: EPS, BVPS, AND COVERAGE
Share repurchases decrease the number of shares outstanding, which can increase EPS (assuming repurchase price is below the firm’s price-to-earnings multiple). Book value per share (BVPS) will rise only if shares are bought below book value per share and fall if repurchased above it.
Worked Example 1.3
XYZ Inc. has 1,000,000 shares, each with a book value of $20 and market price of $35. If the firm repurchases 100,000 shares at market price using cash, what is the effect on BVPS?
Answer:
The firm will spend $3.5 million (100,000 × $35) on the buyback. New equity = $20 million (original) – $3.5 million = $16.5 million. Shares outstanding = 900,000. New BVPS = $16.5 million / 900,000 = $18.33. BVPS decreases, since the shares were bought at a price above book value.
Exam Warning
Mistaking the effect of share repurchases on EPS and BVPS is common. BVPS will only increase if shares are repurchased below their current book value per share. Always use correct values for calculations on the exam.
SUSTAINABILITY OF DIVIDENDS
A high or rising dividend payout ratio may be unsustainable if the firm’s profits decline or if free cash flow is negative. Analysts evaluate sustainability by comparing dividend coverage ratios and assessing free cash flow to equity coverage.
Dividend policies include:
- Stable dividend per share (favored for signaling stability)
- Constant payout ratio (dividends fluctuate directly with earnings)
- Residual payout (dividends paid after profitable investments are funded)
Key Term: constant payout ratio
A dividend policy in which a fixed percentage of net income is paid as dividends each period, causing the dividend amount to vary with earnings.
Summary
Capital structure and payout policy decisions affect both valuation metrics and investor perceptions. Dividends and share repurchases are the primary methods to return cash to shareholders, each with unique signaling and financial effects. Understanding how payout choices influence key metrics and communicate information is critical for the exam.
Key Point Checklist
This article has covered the following key knowledge points:
- Dividend policy theories: irrelevance, bird-in-hand, tax preference
- Main types of dividends and payout methods
- Signaling role of payout changes
- Share repurchase methods and effect on EPS/BVPS
- Dividend and total payout coverage ratios for sustainability
- Factors influencing firm payout choices
- Impact of payout actions on market perception and firm value
Key Terms and Concepts
- payout policy
- regular cash dividend
- share repurchase
- dividend irrelevance theory
- signaling
- EPS (Earnings per Share)
- dividend coverage ratio
- constant payout ratio