Dividend distribution decisions are complicated and involve the understanding of critical strategic factors that affect the policy and value of a firm. Thus, the management of any firm has to consider the constraints on dividend payments, the availability and cost of alternative sources of capital, and other external factors when they create and implement their distribution policy.

Based on your understanding of the constraints on dividend payments, identify the type of constraint this condition represents. Assume that all other factors are held constant.

1. The (impairment of capital rule / bond indenture / preferred stock restriction) states that dividend payments cannot exceed the balance sheet item retained earnings.

2.

3. When a firm has a large number of profitable investment opportunities, it will usually have a (high / low) target payout ratio.

4. A firm that can adjust its debt ratio without raising its weighted average cost of capital (WACC) sharply is (less / more) likely to have a stable dividend policy.

Along with several constraints, several internal factors within a company and external macroeconomic factors affect a firm's dividend policy. In the table, identify which factors, in general, tend to favor high or low payout ratios. Favors a High Payout Favors a Low Payout Factor A firm has limited investment opportunities. A closely held firm has a majority of its shareholders in high, marginal tax brackets. Taxes on capital gains are deferred until the capital gain is realized, but taxes on dividends are due in the year in which they are received