Distribution decisions are complicated and involve the understanding of critical strategic factors that affect the policy and value of a firm. Thus, the management of any firm has to consider the constraints on dividend payments, the availability and cost of alternative sources of capital, and other external factors when they create and implement their distribution policy. Consider the following restriction:
Restrictions on dividend payments based on the liquidity position of the firm.
Based on your understanding of the constraints on dividend payments, identify the type of constraint this condition represents. Assume that all other factors are held constant.
Penalty tax
Impairment of capital rule
Availability of cash
Bond indenture
A company’s dividend policy can also be affected by factors internal to the organization and by the external (macroeconomic) environment in which the business operates. In the table that follows, identify which factors, in general, tend to favor high or low dividend payout ratios.
Factor
Favors a High Payout
Favors a Low Payout
A company has a large retained earnings balance on its balance sheet but has very little cash and almost no other liquid assets.
A company has an established credit line that it can access when it needs an external source of funding.
A closely held firm has a majority of its shareholders in high marginal tax brackets.
Having the ability to accelerate or delay projects makes it easier/harder for a firm to adhere to a stable dividend policy.
If management is concerned with keeping control of the company, it will be likely to retain more/less earnings than it otherwise would to avoid diluting control by issuing new stock to raise capital.