Question

Dividend constraints A firm has $600,000 in paid-in capital, retained earnings of $43,000 (including the current year's earnings), and 30,000 shares of common stock outstanding. In the current year, it has $31,000 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 $0.85 per share have on the firm's balance sheet entries?
c. If the firm cannot 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?

Answer 1

a. The firm cannot pay any cash dividends to the common stockholders because it has negative retained earnings. b. A cash dividend of $0.85 per share would result in an outflow of $0.85 per share for the firm. c. The key constraint with respect to the magnitude of the firm's dividend payments is the availability of retained earnings.

Step-by-step explanation:

a. To calculate the most the firm can pay in cash dividends to each common stockholder, we need to determine the total earnings available for common stockholders. This is done by subtracting the retained earnings from the current year's earnings: $31,000 - $43,000 = -$12,000. Since the firm has negative retained earnings, it cannot pay any cash dividends to the common stockholders.

b. A cash dividend of $0.85 per share would result in an outflow of $0.85 per share for the firm. This would decrease the retained earnings on the balance sheet by the total cash dividends paid.

c. If the firm cannot raise any new funds from external sources, the key constraint with respect to the magnitude of the firm's dividend payments is the availability of retained earnings. If the retained earnings are negative or insufficient, the firm cannot pay cash dividends to the common stockholders.