Legal Contractual and Internal Constraints and Restrictions
The dividend decision is also affected by certain legal, contractual, and internal requirements and constraints. The legal factors stem from certain statutory requirements, the contractual restrictions arise from certain loan covenants and the internal constraints are the result of the firm’s liquidity position.
Legal stipulations do not require a dividend declaration but they specify the conditions under which dividends must be paid. Such conditions pertain to (i) capital impairment, (ii) net profits and (iii) insolvency.
Capital impairment Rules
Legal enactments limit the amount of cash dividends that a firm may pay. A firm cannot pay dividends out of it paid up capital, otherwise there would he a reduction in the capital adversely affecting the security of its lenders. The rationale of this rule lies in protecting the claims of preference shareholders and creditors, on the firm’s assets by providing a sufficient equity base since the creditors have originally relied upon such an equity base while extending credit. Any dividends that impair capital are illegal the directors are personally held liable for the amount of illegal dividend. Therefore, the financial manager should keep in mind that payment of dividend is in order and does not violate capital impairment rules.