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What Is the Connection between Capital Structure and Dividend Policy?

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  • Written By: A. Lyke
  • Edited By: Michelle Arevalo
  • Last Modified Date: 05 September 2016
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A company’s capital structure is the combination of long-term funding sources that provide the organization with an income. Every business has a different capital structure, but common elements of structures include different types of bonds and stocks. Most stocks pay dividends, and higher-paying dividends often cause the company to sell more stocks, increasing the funding in the capital structure. This is the surface relationship between capital structure and dividend policy.

Corporate stocks are ownership shares of the company bought by investors. Often, stocks pay regular dividends, which are returns on the initial investment. Common stocks are stocks issued to the public, with dividends that are usually based on the financial health of the company. Preferred stocks may be offered privately, and have dividends that pay at set rates. Decisions regarding dividend policy have far-reaching consequences that frequently affect a company’s capital structure.

Investing shareholders and companies have the common goal of increasing wealth. Shareholders can only make money from stocks in two ways, either from dividend payments or from selling their shares to other investors. The trading of stock to other shareholders is natural to the business — it doesn’t make or lose money from the trade. A shareholder will sell stock if the price drops or if she thinks the price will drop. Poor financial health, perceived fiscal failing, and the possibility of reduced dividends are all reasons for stock prices to fall.

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Of the two ways that shareholders make money off of stocks, dividend payments have a greater potential to increase the company’s funds. This is because increased dividends may cause shareholders to purchase more stock from the business instead of trading the stocks on the market. The connection between capital structure and dividend policy becomes more complex because increasing dividends reduces the amount of cash financing the company’s financial structure. A company’s financial manager probably won’t risk raising dividend payments unless he expects the company to be able to raise more in stock sales than was spent in dividends.

The primary goal of most corporations is to maximize shareholder value to keep up an inflow of investment money. Paying dividends may temporally appease shareholders, but the spending could decrease the amount of cash available for operating and capital expenditures. This means that corporate financial managers must attempt to strike a balance between capital structure and dividend policy. Spending on increased dividends has the potential to both increase and decrease the amount of funding in the company’s financial structure.

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