7.2 The Effect of Paying a Dividend on a Firm’s Prospective Capitalization
In the course of our earlier discussion of (vertical) capital structure, let’s take a look at the effect of dividends on a firm’s prospective structure. We will see that the choice of paying a dividend or not, will affect the firm’s capital structure going forward.
This analysis is forward-looking. We will answer the question of what the prospective effect will be – on a firm’s capitalization – of paying a cash dividend versus not paying any dividend. This is a complex decision the firm must make, one that has multiple effects, including, once again, the effect on the firm’s capital structure and more.
We will assume that the firm has, in the most recent period, earned positive net income. Will the firm’s leverage, its level of indebtedness, be increased or not as a result of paying the dividend?
| Initial | Paying a Cash Dividend | Not Paying Any Dividend | Paying 100% Dividend | |
| Net Income | $100 | $100 | $100 | |
| Dividend to be paid | (20) | (0) | (100) | |
| Addition to Retained Earnings | $80 | $100 | 0 |
| Debt | 50 | 50 | 50 | 50 |
| Equity | 50 | 130 | 150 | 50 |
| Debt/ Equity (Leverage) Ratio | 1:1 | 1: 2.6 | 1:3 | 1:1 |
Clearly, if a company chooses to pay the dividend, its addition to retained earnings, and hence its capital structure will be “worse,” i.e., more indebted or more leveraged, than if it chose instead not to pay any cash dividend.
Given this analysis, what are the arguments for paying a dividend or not?
