II. Restrictions on Dividend Policy

Because of the cash flow identity, restrictions on dividends are indirect restrictions on investment policy.

Dividend covenants establish a limit on distributions that may occur over the life of the bond by defining an inventory of funds available for dividend payments.

Thus, the maximum dividend that is payable in any quarter is given by:

What are the implications?

How do dividend restrictions serve as indirect restrictions on investment policy?

Dividend Policy and Investment Policy

The restriction on dividends can be combined with the cash flow identity (inflows must equal outflows) to constrain investment policy.

The cash flow identity can be expressed as:

The firm's cash flow can be expressed as follows:

If we substitute for a firm's operating cash flows in the cash flow identity and then solve for dividends we get:

substituting back into the funds available for distribution equation, we get:

Now, if we make the simplifying assumptions that k=1 and F=0, then the firm can only pay dividends if:

What does it mean?

How does placing a maximum on dividends affect investment policy?

What does adding a dip do?

Are just dividends restricted?