Payout Policy with Legal Restrictions
58 Pages Posted: 14 May 2009 Last revised: 25 Feb 2011
Date Written: February 22, 2011
Research suggests that firms can use either debt or dividends as a commitment device to mitigate the free cash flow problem. We hypothesize that firms which face limitations on debt may use increased dividend payments as a second-best bonding device. Limitations on debt are implicit in state laws that restrict the firm from making payouts when the asset-to-liability ratio is low. Consistent with our hypothesis, we find that (i) firms incorporated in states with stricter payout restrictions pay more dividends, (ii) the probability of paying dividends or repurchasing shares decreases as firms approach their binding payout constraint, and (iii) bonding with dividends is less prevalent with increased managerial equity holdings. Further tests examining the relation between firm payout policy and payout restriction laws while controlling for antitakeover and director liability laws confirm our findings.
Keywords: Payout Policy, Capital Structure, State Laws, Bonding Mechanisms
JEL Classification: G35, K22
Suggested Citation: Suggested Citation