Important restrictions on the payment of dividend may be accepted by company when obtaining external capital either by a loan agreement, a debenture indenture, preference share agreement, or a lease contract. Such restrictions may cause the firm to restrict payment of cash dividends until a certain level of earnings has been achieved or limit the amount of dividends paid to a certain amount or percentage of earnings. Since the payment of dividends involves a cash outflow, firms are forced to reinvest the retained earnings within the firm. A restriction on dividends may take three forms. In the first place, firms may be prohibited of paying dividends in excess of a certain percentage, say, 12 per cent. Alternatively, a ceiling terms of the maximum amount of profits that may be used for dividend payment may be down, say not more than 60 per cent of the net profits, or a given absolute amount of such p can be paid as dividends. Finally, dividends may be restricted by insisting upon a minimum earnings to be retained. Reinvestment leads to a lower debt equity ratio and, thus, enhances margin of cushion (safety) for the lenders.
Therefore, contractual constraints on dividend payments are quite common. The payment cash dividend in violation of a restriction would amount to default in the ease of a loan and entire principal would become due and payable. Keeping in view the severity of penalty, financial manager must ensure that the amount of dividend is within the covenants already committed to lenders.