Chartered Financial Analyst (CFA) Practice Exam Level 2

What is the implication of a high dividend payout ratio?

1. Increased shareholder returns with lower growth potential

2. Higher growth potential with reduced shareholder returns

3. Increased investment in company growth

4. Lower risk of capital loss

The correct answer is: Increased shareholder returns with lower growth potential

A high dividend payout ratio indicates that a significant portion of a company's earnings is being distributed to shareholders in the form of dividends rather than being retained for reinvestment in the business. This has specific implications for both shareholder returns and growth potential. When a company pays out a high proportion of its earnings as dividends, shareholders receive immediate income, which can be attractive, particularly for investors seeking regular cash flow. However, the trade-off for this immediate return is that the company has less retained earnings to reinvest into its growth opportunities. As a result, the potential for future growth may be limited because capital that could have been used for expansion, research and development, or other investments is instead paid out to shareholders. Thus, while shareholders enjoy increased returns through dividends, the company may be sacrificing long-term growth, leading to potentially lower capital appreciation in the future. This balance between immediate returns and growth potential is a key consideration for investors analyzing a company’s financial strategy. The other options do not reflect the implications of a high dividend payout ratio accurately, as they suggest scenarios where growth is enhanced or risks are mitigated, which contradicts the challenges that often arise from a high payout.