Credit Risk and Dividend Irrelevance
29 Pages Posted: 23 Apr 2015
Date Written: April 15, 2015
We show how, in a Merton-type model with bankruptcy, the dividend policy impacts the values of equity and debt as well as credit risk. The recent financial crisis has emphasized the fact that excessive dividends can lead to financial distress. There is a strong need to set qualitative and quantitative restrictions on dividends taking into account the potential conflict between equityholders and debtholders. The model that we develop allows for a quantitative setting of restrictions on dividends and gives a useful tool to support dividend payments that may be opposed by debtholders or preclude a distribution when such could otherwise jeopardize the firm. We show the implications of our approach compared to the implications of the Signaling Approach, and the Smoothing Approach. It is shown that the Miller-Modigliani irrelevance of dividends theorem must rely on more assumptions than in the original paper. In this paper, we highlight the role of dividends (and stock repurchases) to possibly mitigate the potential conflict of interests between shareholders and debtholders. The emphasis is on the credibility of the dividend policy.
Keywords: credit spread, dividend policy, Merton’s model
JEL Classification: G12, G13, G15
Suggested Citation: Suggested Citation