Dividend constraints- As firm has $800,000 in paid in-capital, retained earnings
ID: 2445079 • Letter: D
Question
Dividend constraints- As firm has $800,000 in paid in-capital, retained earnings of $40,000 (including the current year’s earnings), and 25,000 shares of common stock outstanding. In the current year, it has $29,000 of earnings available for the common stockholders.
a. What is the most the firm can pay in cash dividends to each common stockholder? (Assume that legal capital includes all paid in capital.)
b. What effect would a cash dividend of $0.80 per share have on the firm’s balance sheet entries?
c. If the firm can’t raise any new funds from external sources, what do you consider the key constraint with respect to the magnitude of the firm’s dividend payments? Why?
Explanation / Answer
The most that the firm can pay as cash dividends is the total amount of retained earnings including the current year earnings. Hence the maximum amount of cash dividend that can be distributed is 40000 . If company pays above this it would be returning the investment to the sharehold * ers
Dividend of 0.80 per share would result in outflow of 0.8*25000 = $20000. Accordingly, 20000 would be reduced from the retained earning account and cash would also be decreased by the same amount
When a firm finances its business with equity it pays dividend as returns and when finances with debt it pays interest as returns. Both dividend and interest are outflows and reduce the funds available with a company.
However, interest cost is beneficial than paying dividend because, interest cost reduces the tax bill while the dividends do not. This is so, becuase while calculating income tax expense, interest cost is deducted to arrive at taxable net income whereas dividend is paid from funds remaining after payment of taxes. So dividend payment is more costly to the firm. In some countries, dividend increases the tax bill as companies declaring dividend has to pay dividend distribution tax apart from income tax