Effect of dividend payout policy on Capital Structure of the firm

TakeAccount1

What are the effects of different dividend-payout levels on the capital structure of a firm?

Web does not give clear suggestions whatsoever!

KingBrian2

Well shareholders receive dividends from the company, these are members that own part of the company and the company is obligated to pay them first and for most. Each shareholder is grouped into different categories with priority given to majority owners.

TakeAccount1

Would I be right in saying that

(i) A zero-dividend payout policy has the effect of lowering the d/e ratio as internal equity is raised by holding onto retained earnings, reducing the need for external financing. It also implies the firm is innovative and growing which may have a positive effect on the share price, maximising shareholder wealth through capital gains. For a company that has an aversion to debt, this is positive for the capital structure of the firm.

(ii) A high-dividend payout increases the need for external financing, which may have a negative impact on the capital structure of a debt-averse firm. In years where earnings are low, the firm may need to borrow in order to pay the dividend, increasing the d/e ratio and increasing the cost of equity. However "optimal capital structure" is seen as one that maximises shareholder wealth and some shareholders place a larger value on receiving dividends than the capital gains from trading shares. Dividends are seen as a more certain form of income.

(iii) A residual dividend payout policy in theory provides firms with the optimal capital structure. In line with M&M dividend irrelevancy theory. Any residual or extra cash generated by the firm could be given out in the form of dividend. However, in reality this could have a negative impact on capital structure as dividend payments would be unpredictable and may have negative or at least fluctuating effects on the share price, thereby affecting the firms cost of capital, WACC and hence shareholder wealth.

(iv) Share buy-back increases d/e ratio of firm, increasing cost of equity but also making firm more susceptible to financial distress and bankruptcy costs.

This make any sense?

KingBrian2

TakeAccount1 wrote: »

Would I be right in saying that

(i) A zero-dividend payout policy has the effect of lowering the d/e ratio as internal equity is raised by holding onto retained earnings, reducing the need for external financing. It also implies the firm is innovative and growing which may have a positive effect on the share price, maximising shareholder wealth through capital gains. For a company that has an aversion to debt, this is positive for the capital structure of the firm.

(ii) A high-dividend payout increases the need for external financing, which may have a negative impact on the capital structure of a debt-averse firm. In years where earnings are low, the firm may need to borrow in order to pay the dividend, increasing the d/e ratio and increasing the cost of equity. However "optimal capital structure" is seen as one that maximises shareholder wealth and some shareholders place a larger value on receiving dividends than the capital gains from trading shares. Dividends are seen as a more certain form of income.

(iii) A residual dividend payout policy in theory provides firms with the optimal capital structure. In line with M&M dividend irrelevancy theory. Any residual or extra cash generated by the firm could be given out in the form of dividend. However, in reality this could have a negative impact on capital structure as dividend payments would be unpredictable and may have negative or at least fluctuating effects on the share price, thereby affecting the firms cost of capital, WACC and hence shareholder wealth.

(iv) Share buy-back increases d/e ratio of firm, increasing cost of equity but also making firm more susceptible to financial distress and bankruptcy costs.

This make any sense?

Without going into the nuances of my limited knowledge on corporate finance I would say ii sounds right. Companies would borrow more when earnings are low contributing to the need to keep profits to reinvest in the company while shareholders definitely to me would be very eager to have their dividends paid to them as soon as possible. Maybe building equity is what some shareholders want not the majority.