I understand the bondholder most time include in the bond indenture that the company cannot divident payment to equity investors. If a company decides to pay higher dividend to equity investors, will the dividend payment not be after the bondholder coupon payment has been made? Why would bondholder insist on cause that restrict dividend to equity investors? Or is it only applicable in the event of financial distress and bankruptcy?. Thank you.
yes - dividend payment to common stockholders will be made after the pecking order is met.
Pecking order
a) Bond Holders
b) Preferred stock holder dividends
and finally - Common Stock holders
This is not really an issue if the company is doing well and is profitable. But in case the profitability falls or if the company is heading into bankruptcy - this needs to be enforced - so that funds that need to be provided to the bond holders are not reduced. They need to be paid first, and then the remaining funds go to the other investors.
Dividends derease equity. Bond covenants and banks typically require certain levels of “Tangible Equity” (defined in covenants). If you pay a dividend, you are decreasing your equity. Debtholders view this equity as a cushion, so by paying dividends you are decreasing the cushion… From the debtholder’s point of view, they like a cushion. From an owner’s point of view, they like flexibility to do what they wish with accumulated earnings. So the two sides negotiate what the covenants will look like.
This year’s dividends may come after this year’s interest payments, but they come before _ next year’s _ interest payments; a whacking big dividend this year may impair the company’s ability to make its coupon payments _ next year _.
Whaoo, Thank you Magician, this definitely cleared up the air…
Thank you everyone…