Sustainability of Cash Dividends

The following are characteristics of companies that may not be able to sustain their cash dividends:

1. Small, young companies: Small companies cannot sustain their cash dividend because earnings are ploughed back into the business.
2. They are in an industry that is highly volatile, e.g., technology and pharmaceutical: They uses a lot of cash to respond to future developments in their industry.
3. They spend more money on research and development; thus, they do not have free cash to distribute dividends.
4. They have many profitable investment opportunities and will opt to use cash than debt or issuing new equity to finance the positive NPV projects because internally generated funds are cheaper.
5. They have a relatively lower return on assets.
6. They have relatively high debt ratios.
7. They are under financial and operating distress.

Question

Which of the following is the most likely reason for a company’s inability to sustain cash dividends?

1. Low research and development expenditure.
2. Financial and operating distress.
3. High return on assets.

Solution

The correct answer is B.

Companies under financial and operating distress do not have enough earnings to pay out cash dividends regularly.

A is incorrect. Companies that do not spend much on research and development have more cash to distribute to shareholders; thus, they will regularly pay cash dividends.

C is incorrect. This is a characteristic of a company that pays cash dividends regularly.

Reading 18: Analysis of Dividends and Share Repurchases

LOS 18 (n) Identify characteristics of companies that may not be able to sustain their cash dividend.