Chapter 15, Problem 1RQ

What does the trust indenture used by a corporation in creating long-term bonded indebtedness have to do with the payment of dividends on common stock?

To determine

Explain the importance of the trust indenture related to the payment of the dividend on common stock.

Explanation of Solution

Trust indenture:

Trust indenture is a formal document that creates the indebtedness of the bond or debt. When the company borrows the funds for a long duration (20 years or more), then it is considered as long-term debt. Trust indenture is a formal document that states the liability of the company regarding the bond or debt.

Explain the importance of the trust indenture related to the payment of the dividend on common stock:

Trust indenture is prepared to establish some restrictions on the borrowing company. It is prepared to protect the rights of the bondholder.  The trust indenture proposes the company should not give an unfair advantage to the shareholders of the company over bondholder.

Trust indenture would provide restrictions on the company that it should not declare dividend when it could cause the working capital shortage in the company. It provides the advantage to the bondholder for their payment of capital and interest over shareholders.

Thus, trust indenture provides the advantage to the bondholder about the payment priority.