Page 28 - FINAL CFA II SLIDES JUNE 2019 DAY 6

LOS 22.g: Compare stable dividend, constant dividend payout ratio, and
residual dividend payout policies, and calculate the dividend under each READING 22: DIVIDENDS AND SHARE REPURCHASES: ANALYSIS
policy.
Stable Dividend Policy: Steady dividend payout, even though earnings may be volatile
from year to year. This typically means aligning dividend growth rate with long-term earnings MODULE 22.2: STOCK BUYBACKS
growth rate; could be gradually moving towards a target dividend payout ratio.

expected increase in dividends = [(expected earnings × target payout ratio) – previous dividend] × adjustment factor

where: adjustment factor = 1 / number of years over which the adjustment in dividends will take place

EXAMPLE: Expected dividend based on a target payout adjustment approach: Last year, Buckeye, Inc., had earnings of $3.50 per share and paid a dividend of
$0.70. In the current year, the company expects to earn $4.50 per share. The company has a 35% target payout ratio and plans to bring its dividend up to the target payout
ratio over a 5-year period. Calculate the expected dividend for the current year using the target payout adjustment model.

= [($4.50 × 35%) – $0.70] × 0.2 = $0.175 expected dividend for the current year = previous dividend + expected increase in dividends = $0.70 + $0.175 = $0.875

NOTE: The payout ratio actually falls from 20% to 19.4% which defied the constant growth idea. The target payout adjustment approach is expected to
work in the long-run, even though year-to-year. results may defy the logic behind it.

Constant Dividend Payout Ratio Policy: Represents the proportion of earnings that a company plans to pay out to shareholders (amount would vary
directly with earnings - seldom used).

Residual Dividend Model: Based on earnings less funds retained to finance the equity portion of capital budget. The model is based on (1) investment
opportunity schedule (IOS), (2) target capital structure, and (3) access to and cost of external capital:
Step 1: Identify the optimal capital budget.
Step 2: Determine the amount of equity needed to finance that capital budget for a given capital structure.
Step 3: Meet equity requirements to the maximum extent possible with retained earnings.
Step 4: Pay dividends with the “residual” earnings that are available after the needs of the optimal capital budget are supported. In other words, the residual policy implies that
dividends are paid out of leftover earnings.
EXAMPLE: Dividends under the residual dividend model. Answer: Larson has a target debt-to-equity ratio of 0.5: Assets, A, are $3.00 = $1.00 + $2.00,
Suppose Larson Company has $1,000 in earnings and $900 in so the capital structure is D/A = 1/3 and E/A = 2/3).
planned capital spending (representing positive NPV projects).
Larson has a target debt-to-equity ratio of 0.5. Calculate the If planned capital spending < total amount of capital available, the firm can pay dividends.
company’s dividend under a residual dividend policy. To maintain the target capital structure, the $900 capital spending will be financed with
[(1/3)($900)] = $300 of debt and [(2/3)($900)] = $600 of equity.

Residual = ($1,000 − $600) = $400 = Dividends!