The Effects of Debt on Dividend Policy

More debt means more interest due and less money available to pay dividends

The question of what factors determine a company's dividend policy is a matter of a good deal of controversy, both in boardrooms and in universities. There is little room for doubt, though, that in many situations corporations feel constrained by their debt load and minimize or suspend dividends in order to service debt.

Significance

Ford Motor decided in May 2010 not to pay dividends because "we still have a lot of debt."

An obvious impact of debt upon a company's dividend policy is that a company with a lot of debt must keep up with interest payments, and this limits the cash flow available to pay dividends.

Debt Covenants

A debt covenant is a formal agreement between lenders and a borrower about how the latter will conduct business. These covenants often explicitly limit dividends.

Signaling the Market

In 2003, Congress cut the tax rate on stock dividends to no more than 15 percent.

A company may want to pay dividends, whatever its level of debt, because one of the functions of a dividend payment is to signal the market that the issuer is confident and healthy.

References

• UPI Business News: Ford Puts Its Debt Ahead of Dividends
• NYU Stern: Dividend Policy
• Tampa Bay Business Journal: Latest Installment of the TBBJS Index

Resources

• Dividends Value: Low-Debt Dividend Stocks