Running head: Capital structure and dividend payout 1

Capital structure and dividend payout

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 Capital structure and dividend payout 2

Maintaining a debt ratio of 70 percent in the company’s capital structure represents a high

leveraged position in which the company relies more on the debt financing rather than the equity

finance. One of the advantages of such position include minimum taxes paid as debts reduces the

amount of profits paid by the company as taxes. Also, the high leverage is considered a sign of

growth of the company in that the company use more of the borrowed funds in financing growth.

Relying more on debts reduces chances of the company having dilution of ownership as creditors

are not owners of the company. However, there are disadvantages associated with maintaining

the debt level at 70 percent. One of the disadvantages is that it increases the financial risk of the

company which makes the company prone to bankruptcy. Also, it reduces credibility of the

company to gain financial assistance from institutions AL-Shatnawi et al, 2021)

Direct costs associated with financial distress include legal fees, liquidation fees, broker

fees and auditor’s fees. Examples of indirect costs associated with financial distress include

firm’s reputation, less favorable credit terms, opportunity costs and loss of customers. Agency

costs that are incurred during financial distress in an organization include monitoring cost paid to

the board of directors by the shareholders to monitor activities of the organization. Other agency

costs associated with financial distress include bonding costs and residual losses. Attorney fees

and liquidation fees can also be classified under the classification (Ayash & Rastad, 2021)

A positive covenant is a promise made during contractual agreement among parties

which require the company to perform certain activities or duties. It reduces the cost of

borrowing through enhancing certain borrowing restrictions on the borrower. A negative

covenant on the other hand, prevents the borrower of the funds from engaging in certain

activities particularly with the use of the funds borrowed from the lender. Debt consolidation as
 Capital structure and dividend payout 3

used in the presentation is the act of using borrowed funds to settle liabilities or another debt

(Wang & Zheng, 2020).

The Pecking order theory has rules on the procedure followed in determining the

financing option in the company. According to the theory, the company should finance itself

internally using the retained earnings. If the retained earnings is insufficient to support growth,

the company should use debts but if the leverage capacity is worse to secure debts, the company

should use equity finance but the option should be the last resort. Based on the outlined rules, the

implications of the pecking order theory is that high profitable companies that generate high

retained earnings are expected to use less debt capital. Low profitability of a firm may result into

high leverage due to increased debts. In addition to the implications is that high reliance of debt

finance may affect the cost of equity of in a growing company (Yıldırım & Çelik, 2020).

High-dividend policy can be supported by presence of factors such as stability of earning.

If the earnings of Baldwin are stable, the management can easily formulate a high dividend

policy. Another factor is the growth needs of the company where the more the needs the less the

amount of profits retained in the business tom pay dividends. Also, the profit rate of the company

determines the amount of profits paid to the stockholders as dividends. In addition to the factors

is the financial policy of the company in that the company has to comply with the policies

developed dictating the dividend payout policy. The board of directors can pay the dividends as

money by depositing it to the bank accounts of the shareholders. Also, the board of directors can

pay dividends as partly cash and partly as promissory notes where they promise to pay the

remaining amount in future. In addition to the approaches is property where a property is issued

and the current market price of the asset recorded against the payment.
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In developing a sensible dividend policy for the company, three main characteristics are

to be used. One of the characteristics is constant payout ratio which ensure shareholders are

entitled to a constant amount of returns for the invested stock. The second characteristic to

incorporate in the policy is regular dividend policy to ensure the dividends are made more often.

The third characteristic is extra dividend policy to allow additional dividends to be made if the

company makes much profits. Other characteristics to include in the policy is the date at which

dividends are defined and the proportion used in determining the dividend amount (Soewignyo,

2020).
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Reference

AL-Shatnawi, H. M., Hamawandy, N. M., Mahammad Sharif, R. J., & Al-Kake, F. (2021). The

role of the size and growth rate of the bank in determining the effect of financial leverage

on the profitability of Jordanian commercial banks. Journal of Contemporary Issues in

Business and Government, 27(1), 1962-1978.

Ayash, B., & Rastad, M. (2021). Leveraged buyouts and financial distress. Finance Research

Letters, 38, 101452.

Soewignyo, T. I. (2020). Analysis of the Effect of Profitability, Solvability, and Dividend Policy

on Banking Firm Value. Human Behavior, Development and Society, 21(1), 28-37.

Wang, W., & Zheng, K. (2020). Real earnings manipulation and future performance: A revisit

using quarterly data of firms with debt covenants. Review of Financial Economics, 38(1),

76-96.

Yıldırım, D., & Çelik, A. K. (2020). Testing the pecking order theory of capital structure:

Evidence from Turkey using panel quantile regression approach. Borsa Istanbul Review.