Question

Quick Mart has been paying a quarterly dividend of $1.20 a share. Which of the following are valid reasons for the firm to reduce or eliminate these dividends?

I. The firm is on the verge of violating a bond restriction.

II. The firm wants to save cash for an acquisition with a 40 percent premium.

III. The firm can raise new capital easily at a very low cost.

IV. Congress just changed the tax laws eliminating all taxes on capital gains.

Answers:

I and IV only

Could you explain why I and IV are the answers and why other choices are incorrect?

Answer 1

I. Many bonds have restrictions which do not allow high dividends. In case a firm violates this, then the firm's bond rating is degraded which in turn increases the costs of borrowing for the firm. This impacts the cost of capital of firm's projects. Therefore, this is a valid reason.

II. I'm not so sure about this, but this seems like high valuation case as 40% premium seems pretty high. The shareholders may not like their earnings being wasted on a overvalued target.

III. If the firm can easily raise capital externally at a very cost, then their is no need to save. Savings or retained earnings are generally preferred due to high external financing costs.

IV. Consider this case : With capital gains, Purchase price : $50, Sale price : 60, Dividend = $5, Capital gain tax = 10%

Earnings of a shareholder = $5 + ($60 - $50) x (1 - 0.10) = $14

Without capital gain, Purchase price : $50, Sale price : $60, Dividend = $4

Earnings of a shareholder = $5 + ($60 - $50) = $14

Therefore, even if the dividends are reduced, the earnings of the shareholders remain the same. So, in case capital gains are abolished, a firm may look into reducing the dividends so that it can save more for projects. But, it has to keep in mind that earnings of the shareholders should not reduce.