Question

Question 6 You have recently been appointed CEO of Wizard House Ltd., a wholesale distributor of magic supplies. One day your CFO reminds you that next week you will have to make recommendations to the board of directors regarding this year's annual dividend. This catches you totally by surprise. Luckily, the CFO was kind enough to provide you with some additional information. He shows you the projected income statement and balance sheet, without the effect of any dividend declaration. Income Statement: Sales............ 44,000,000 COGS............... 29,400,000 Gross profit...... 14,600,000 Operating expenses..... 6,000,000 Operating income before interest.......... 8,600,000 Interest expense....... 1,000,000 Income before tax...... 7,600,000 Income tax (30%)............................... 2,300,000 Net income. 5,300,000 Statement of Financial Position: Current Assets Cash 4,000,000 Accounts receivable..... 5,000,000 Inventory.................. 2,000,000 Other.... ................. .... 3,700,000 Total Current Assets... 14,700,000 Long-term investments............ 7,000,000 Property, plant and equipment (net). 17,000,000 Total Assets. 38,700,000 Current Liabilities Accounts payable. Accrued liabilities....... Other... 2,000,000 3,000,000 4,000,000 9,000,000 16,000,000 Total Current Liabilities........ Non-current liabilities. Shareholders' Equity Common shares. Contributed surplus.... Retained earnings (includes this year's net income).... Total Shareholders' Equity. Total Liabilities and Equity... 1,000,000 4,900,000 7,800,000 13,700,000 38,700,000 Other information: 1) Last year, the net income was $3,500,000, and $3,300,000 cash dividends were paid. 2) Wizard House has two debt agreements that call for the corporation to maintain at least $2,500,000 in retained earnings, as well as maintain a debt-to-total-assets ratio of no more than 70%. 3) There has been no change in the number of shares outstanding during the year. You start to think about the recommendations you are going to make. It is the end of November, and historically the corporation has declared dividends five days before the end of the year. Instructions a) What factors will limit the amount to be distributed as dividends? b) What are important considerations in your decision? What would you recommend? Provide any journal entry that is related to your decision.

Answer 1

(A)Factors that will limit the amount to be distributed as dividends :

• The company have to ensure debt to total assets ratio is less than 70% after dividend distribution.
• The retained earnings should not be less than $ 2,500,000 after dividend distribution
• The future capital expenditure plans of the company
• Cash flow position of the company and its cost of raising funds from alternative resources
• Statutory provisions, tax rules, legal provisions and guidelines regarding dividend distribution

(b) Here, nothing about the future growth plans of the company and rules and regulation regarding dividend distribution is given.

Hence the our importance consideration is

• Debt to total assets ratio is less than 70%

Debt/total asset= 70%

=> 25,000,000 / (38,700,000-x) = 70% where x is the amount to be distributed as dividend

=> 25,000,0000 = 27,090,000 - 0.7 x

=> 0.7 x = 2,090,000

=> x = 2,985,714.28

Hence as per this, maximum amount amount to be distributed = 2,985,714.28

• Retained earning should have at least $2,500,000

Hence, maximum amount to be taken from retained earnings = 7,800,000 - 2,500,000

= 5,300,0000

Recommendation

To get debt to total asset ratio not more than 70%, maximum amount to be distributed = 2,985,714.28

Maximum amount to be taken from retained earnings = 5,300,000

Therefore, as per my recommendation, amount to be distributed as dividend = 2,985,714.00(rounded)

_{JOURNAL ENTRY}

Retained earnings Dr 2,985,714

To Dividend payable 2,985,714

( being dividend declared)

Dividend payable Dr 2,985,714

To cash 2,985,714

( being payment of final dividend )