Question

Which of the following are not legitimate constraints on the dividends a firm will pay to​ shareholders?
A. Dividends may be constrained by the amount of cash a firm has.
B. Bondholders may have covenants limiting the amount of the dividend.
C. Dividends must not eat into legal capital.
D. All are legitimate constraints on the dividends that firms choose to pay to shareholders.

Answer 1

Answer:

D. All are legitimate constraints on the dividends that firms choose to pay to shareholders.

Explanation:

All of these are legitimate constraints.

For A, a company may simply have limited cash flows and as such can not pay any dividends. They may still be making profits and may declare dividends but the payment may not be made until subsequent period when cash is available.

For B, Bondholder covenants legally bind firms as issuing authorities from certain practices, for example a bond covenant may bind a firm to have interest cover of at least 2 times retained and as such there may be very little retained earnings left to pay for dividends.

For C, some forms of businesses like insurance companies or banks are restricted by law that they can not pay dividends if it means a capital reduction. These businesses have legal capital requirements that they must maintain and thus they cannot reduce capital in lieu of making dividend payments.

Hope that helps.