Answer the following. (a) Suppose a new bond issue includes a covenant prohibiti

Question

Answer the following. (a) Suppose a new bond issue includes a covenant prohibiting the use of special dividends. What agency conflict is this sort of restrictive covenant intended to solve? (b) Now suppose that firm performance is significantly higher than anticipated, so that equity free cash flow is very high. This abnormally good performance is not expected to continue. Assume the firm has no growth prospects. Explain why the firms managers would hesitate to raise their level of common dividend to distribute this extra cash. (c) If the cash is not distributed, what agency problem does this create?

Explanation / Answer

1. The Covenant which prohibits the use of special dividend is intended to solve the agency conflict between the bondholders and the shareholders of the company. Restricting the use of special dividends will ensure that the additional income earned by the company after paying off bondholders and shareholders is retained within the company and used for the growth of the company. Also the bondholders want to ensure that in future the company is not short of cash to make the interest payments.

2. Since the abnormally good performance is not expected to continue the managers would hesitate to raise their level of common dividend so as to keep the stockholder expectation within control. If the extra cash is distributed as dividend the Expectations of the shareholders will increase. When in future the growth does not continue and the company is not able to pay dividends the abnormally high expectations will lead to a decline in the stock price of the company.

3. If the cash is not distributed It results in an agency problem between the management and the shareholders. The shareholders would want additional dividends however the managers would want to retain the additional cash for the future requirements of the company.

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