CFA Level 2 | Analysis of Dividends and Share Repurchases

CFA Level 2 | Corporate Issuers| Learning Module 1

Dividends: Forms and Effects

  • Dividend: A distribution paid to shareholders, declared by the board of directors. Payment is discretionary and not a legal obligation.
  • Regular Cash Dividend: Paid on a regular schedule (e.g., quarterly, semiannually) and often aimed to be maintained or increased. Signals company growth and management confidence.
  • Extra (Special, Irregular) Dividend: A one-time payment in addition to regular dividends, often due to special circumstances like asset sales or spin-offs. Used by cyclical companies to distribute earnings in strong years.
  • Liquidating Dividend: A return of capital when a company goes out of business, sells a portion of its business, or pays dividends exceeding retained earnings.
  • Stock Dividend (Bonus Issue/Scrip Dividend): Distribution of additional shares to existing shareholders (typically 2-10%) instead of cash.
    • Reduces cost per share but total shareholder wealth and company’s economic value remain unchanged.
    • Accounting Impact: Reduces retained earnings and increases contributed capital, but total shareholders’ equity is unaffected. Liquidity and leverage ratios are unchanged.
  • Stock Split: Increases the number of outstanding shares and proportionally reduces the share price (e.g., a two-for-one split doubles shares and halves price).
    • Shareholder wealth is unchanged.
    • All per-share data (EPS, DPS) are reduced proportionally.
    • Accounting Impact: No effect on shareholder equity account balances.
  • Reverse Stock Split: Reduces the number of outstanding shares and proportionally increases the share price, often used by companies with very low share prices to meet listing requirements.
    • Shareholder wealth is generally unchanged.

Dividend Policy and Company Value: Theories

  • Dividend Policy: Decisions about whether, when, and in what amount to pay dividends.
  • Miller and Modigliani (MM) Dividend Irrelevance Theory (1961): In a perfect world (no taxes, transaction costs, symmetric information), dividend policy has no impact on the cost of capital or shareholder wealth.
    • Dividend decision is independent of investment and financing decisions.
    • Homemade Dividend: Shareholders can create their desired cash flow by selling shares, making company-paid dividends redundant.
    • No meaningful distinction between dividends and share repurchases under MM assumptions.
  • Dividend Relevance Theories: Argue that dividend policy does matter due to market imperfections.
    • Taxes: If dividends are taxed differently than capital gains, investors may have preferences.
    • Asymmetric Information (Signaling): Managers have more information than outside investors; dividend actions can convey signals about future prospects.
    • Agency Costs: Conflicts of interest between managers and shareholders (e.g., overinvestment) can be affected by payout policy.

Other Theoretical Issues: Signaling

  • Dividend initiations and increases generally convey positive information about future earnings growth and are associated with excess returns.
  • Dividend omissions and reductions generally convey negative information about future earnings problems. Maintaining a dividend during stress can be viewed positively.
  • Dividend announcements can help resolve information asymmetry between insiders and outsiders.
  • Costly Signaling: Dividend increases are costly to mimic for companies with poor prospects because they may not be sustainable, leading to future dividend cuts or the need for costly external financing.

Agency Costs and Dividends

  • Jensen’s Free Cash Flow Hypothesis: Paying out free cash flow as dividends can limit managers’ ability to overinvest in negative NPV projects, mitigating the overinvestment agency problem.
  • Dividends can exacerbate the agency conflict between shareholders and bondholders by reducing the cash cushion available for debt payments and potentially leading to underinvestment.
  • Bond indentures often include covenants restricting dividend payments to protect bondholders.

For more information about our CFA exam prep courses, check out our CFA Level 2 All-In-One Prep Course or the CFA Level 2 Corporate Issuers e-learning course.