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101 Concepts for the Level II Exam

Level II Concept 37: Dividend payout policies


Stable dividend policy:

In this policy, a company tries to align its dividend growth rate to the company’s long-term earnings growth rate. The stable dividend policy can be represented by a gradual adjustment process in which the expected increase in dividends is calculated as:

Expected increase in dividends = (Expected earnings × Target payout ratio – Previous dividend) × Adjustment factor

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

New dividend = Original dividend + Increase in dividend

 

Example: Current dividend = 0.4. Expected earnings for the year ahead = 1.50. Target payout ratio = 0.5. Adjustment period = 5 years. Calculate the expected dividend.

Solution:

Adjustment factor = 1/5 = 0.2

Expected increase in dividends = (1.5 x 0.5 – 0.4) x 0.2 = 0.07

Expected dividend = 0.4 + 0.07 = 0.47

Constant dividend payout ratio policy:

In this policy, a company applies a target dividend payout ratio to current earnings; therefore, dividends are more volatile than with a stable dividend policy.

Residual Dividend Policy:

In this policy, the amount of the annual dividend is equal to the internally generated funds remaining after financing the current period’s capital expenditures consistent with the target capital structure.

Dividend = Earnings – (Capital budget ×Equity percent in capital structure)