Dividend policy is a tool for changing financing mix

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Dividend policy cannot be analyzed in a vacuum. Firms can use dividend policy as a tool to change their debt ratios, In chapter 9, we examined how firms that want to increase or decrease leverage can do so by changing their dividend policy: increasing dividends increases leverage over time, and decreasing dividends reduces leverage.

When dividends increase, stockholders sometimes get a bonus in the form of a wealth transfer from lenders to the firm. Lenders would rather have firms accumulate cash than pay it out as dividends. The payment of dividends takes cash out of the firm, and this cash could have been used to cover outstanding interest or principal payments. Not surprisingly, bond prices decline on the announcement of large increases in dividends. It is equity investors who gain from the loss in market value faced by bondholders. Bondholders, of course, try to protect themselves against this loss by restricting how much firms can pay out in dividends.

Returns: An Empirical Analysis, Journal of Finance, Vol 36, 1-12.

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