Page 24 - FINAL CFA II SLIDES JUNE 2019 DAY 6

LOS 22.e: Explain factors that affect dividend READING 22: DIVIDENDS AND SHARE REPURCHASES: ANALYSIS
policy in practice – 6 factors!

MODULE 22.1: THEORIES OF DIVIDEND POLICY
1. Investment opportunities
2. Expected volatility of future earnings: When earnings are volatile, firms
are more cautious in changing dividend payout.

3. Financial flexibility: Doing stock repurchases instead of dividends as there is no expectation to maintain these compared to dividends. But also
hoarding cash on hand affords flexibility to meet unforeseen operating needs and investment opportunities.
4. Tax considerations: See dividend versus capital gain tax rates just discussed!
5. Flotation costs: Generally, the higher the floatation costs, the lower the dividend payout, given the need for equity capital in positive NPV projects.
6. Contractual and legal restrictions. Companies may be restricted from paying dividends either by legal requirements or by implicit restrictions
caused by cash needs of the business (impairment of capital rule, Debt covenants).

LOS 22.f: 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.

Per the double-taxation system, earnings are taxed at the corporate level and dividends are taxed again at the shareholder level.
effective tax rate (ETR) = corporate tax rate + (1 − corporate tax rate)(individual tax rate)

EXAMPLE: Effective tax rate under a double taxation system: A U.S. company’s annual earnings are $300, and the corporate tax rate is 35%.
Assume that the company pays out 100% of its earnings as dividends. Calculate the effective tax rate on a dollar of corporate earnings paid out
as dividends assuming a 15% tax rate on dividend income.
A split-rate corporate tax system taxes earnings distributed as dividends at a lower rate than
earnings retained. To offset the higher (double) tax rate applied to dividends at the individual level.
ETR is similar to prior case except that the corporate tax rate (CTR) applicable would be the
corporate tax rate for distributed income (not the ratained income component).

EXAMPLE: Effective tax rate under a split-rate system: A German company’s annual pretax
earnings are €300. The CTR on retained earnings is 35%, and the CTR to earnings paid out as
dividends is 20%. Assuming that the company pays out 50% of its earnings as dividends, and
the individual tax rate that applies to dividends is 30%, calculate the ETR on one euro of
corporate earnings paid out as a dividend.

Answer: = 20% + [(1 − 20%) × 30%] = 44%
Earnings distributed as dividends still taxed twice, but at a lower CTR applicable to income).