Recognise the traits of firms whose cash dividend may prove unsustainable
The idea
Warning signs that a dividend may be cut include coverage by net income close to or below 1, FCFE that does not cover the dividend, rising leverage suggesting the payout is being borrowed, declining or volatile earnings, and a dividend yield far above peers, which often means the market already doubts the payment. A long record of unchanged dividends is not proof of safety if cash flow no longer supports it. Distinguish the regular dividend from discretionary repurchases: a company whose total payout exceeds FCFE only because of buybacks it can stop may still have a secure dividend. The trap is treating a high yield as attractive without asking why it is high.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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- Explain the expected impact on shareholder wealth and on a company's financial ratios of cash dividends (regular, extra or liquidating), stock dividends, reverse stock splits and stock splits
- Contrast the main dividend policy theories and, for a described dividend decision by a company, explain what each theory implies for its share value
- Explain what signals a company may send by starting, raising, cutting or omitting its dividend
- Set out the ways agency costs can influence a firm's payout policy
- Set out what shapes the dividend policies companies actually adopt
- Work out and explain the effective tax rate borne by each currency unit a company earns, under double-taxation, imputation and split-rate tax regimes
- Contrast a stable dividend policy with a constant payout ratio policy and work out the dividend each would produce
- Outline how corporate payout policies have broadly changed over time
- Contrast the ways a firm can buy back shares
- Work out and contrast how a share buyback affects EPS when it is funded 1) from surplus cash and 2) with borrowed money
- Work out how buying back shares changes book value per share
- Weigh up returning cash through dividends against buying back shares
- Work out and explain how well dividends are covered, measured against free cash flow and against net income