Question

There are three practical considerations in selecting a firm's dividend policy: restriction on legal capitals, restrictive bondholder covenants, and constraints on cash availability.

Define and discuss each of these items and the impact of each on the information of a firm's dividend policy.

Answer 1

These factors do affect the dividend policy of a firm and can impact what kind of dividend policy is being followed by firm.

· Restriction on legal capital is when the company is restricted by a covenant to raise further debt in order to protect the interest of the existing debt holder. If the company can not raise fresh capital then for new investment it will have to retain the profits and the company can not issue dividends to its shareholders until all the capital expenditure requirement is met. Restriction on raising capital forces the firms to not pay dividend or cut back dividend.

· Restrictive bond holders’ covenants are an agreement while raising funds through debt where the company has to first make sure that it has enough free cash flow available in order to pay the bond holders first and then only it can consider the dividend to stock holders. These covenants also restrict the company from issuing fresh debt until the existing is paid fully.

· Cash availability is one of the most important factors because even if the company is very big but it does not have sufficient cash flows it can not consider issuing dividend. It can consider paying dividend in the form of stock but cash dividend would not be feasible.