It is important for a firm to establish a general policy with respect to the payment of cash dividends. Factors affecting dividend policy include certain legal, contractual, and internal constraints, the firms’ growth prospects, owner considerations, and market considerations.
The firms dividend policy is often constrained by certain legal, contractual/ or internal factors. The legal factors result from certain state, the contractual constraints typically result from certain loan covenants, and the internal constraints are the result of the firms’ liquid –asset position. There are four basic legal constraints confronting the corporation with respect to cash dividend payments. They concern capital, net profits, insolvency, and accumulation of excess profits. Most states prohibit corporations from paying out as cash dividends any portion of the firm’s capital stock as measured by the par value of common stock, but also any capital paid –in excess of par. Capital impairment restrictions are generally established in order to provide a sufficient equity base to protect creditors’ claims on the firm’s assets.
If a firm has overdue liabilities or legally insolvent, the payment of cash dividends is prohibited, this restriction is intended to protect the firm’s creditors by prohibiting the liquidation of a near-bankrupt firm through the payment of cash dividends to owners. The payment of cash dividends by an insolvent firm could seriously impair its creditors claim in bankruptcy.