The chief financial officer of the company has proposed two ways to distribute common shares and still manage to pay cash dividends
Accounting & FinanceGeneralWorked Solution
It’s July 1, 2015, and the market price of Warm Ways’ common stock (Problem P15-3) is $175 per share. There are 1.1 million common shares outstanding, and the Retained earnings account shows a balance of $45,000,000. Management wants to declare and pay a 20% common stock dividend, but this would mean halting the company’s cash dividend payments because a 20% stock dividend would cause retained earnings to fall by $38,500,000 (that is, 20% 3 1.1 million shares 3 $175 per share). This would leave a balance of only $6,500,000, far below the $25,000,000 minimum required for cash dividends as specified in the company’s loan agreement. It would take several years to build up retained earnings so that Warm Ways could again pay cash dividends.
The chief financial officer of the company has proposed two ways to distribute common shares and still manage to pay cash dividends:
• Option A: Split the stock 12 for 10.
• Option B: Increase the size of the stock dividend from 20% to 30%, and record the share distribution as a stock split.
Required:
1. How will these two approaches affect the company’s retained earnings?
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2. As a common stockholder, would you prefer a 20% stock dividend, a 12-for-10 stock split, or a 30% stock dividend? Why?
SOLUTION
Requirement 1:
Both options allow the company to avoid violating the limit on cash dividend payments. With regard to option A, a stock split of 12 for 10 means investors exchange 10 shares of common stock for 12 shares of “new” common stock. This option has no effect on the balance in the retained earnings account. All that would occur is that the par value of the stock would be reduced from $6 to $5 (i.e., 10/12 x $6), and additional shares would be issued to stockholders. Option B also allows the company to avoid violating the limit on cash dividend payments. By increasing the size of the stock dividend from 20% to 30%, the company can use the par-value method rather than the market-value method of recording the dividend. Retained earnings would be reduced by the par-value of stock issued, or $1,980,000 (30% x 1,100,000 shares x $6 per share) but this will not violate the dividend constraint.
Requirement 2:
Stockholders prefer cash dividends and stock price appreciation to just more pieces of paper. All three of these options—20% stock dividend, a 12-for-10 stock split, and a 30% stock dividend—increase the number of shares held but don’t add real value to the investment portfolio. The stock split, at least, doesn’t reduce retained earnings, so it leaves open the possibility of higher cash dividend payments in the future. Otherwise, it is not clear that stockholders will have a strong preference for any of these options.