Problem 1 - Accounting

Question

Fairmount Inc., a developer of radiology equipment, has stock outstanding as follows: 15,000 shares of cumulative \(2 \%\), preferred stock of \(\$ 150\) par, and 50,000 shares of \(\$ 5\) par common. During its first four years of operations, the following amounts were distributed as dividends: first year, \(\$ 30,000\); second year, \(\$ 42,000\); third year, \(\$ 90,000\); fourth year, \(\$ 120,000\). Calculate the dividends per share on each class of stock for each of the four years.

Step-by-Step Solution

Answer

Year 1: Preferred $2, Common $0; Year 2: Preferred $2.8, Common $0; Year 3: Preferred $4.2, Common $0.54; Year 4: Preferred $3, Common $1.5.

Step 1: Calculate Annual Preferred Dividend Requirement

First, determine the total annual dividend required for the preferred stock. The preferred stock dividend rate is 2% on a $150 par value. Thus, the annual dividend per share for preferred stock is calculated as \(150 \times 0.02 = 3\) dollars. With 15,000 shares outstanding, the total annual preferred dividend is \(15,000 \times 3 = 45,000\) dollars.

Step 2: Distribute First Year Dividend

In the first year, \(30,000 is distributed, which is less than the \)45,000 preferred dividend requirement. Since the preferred shares are cumulative and the full requirement was not met, the entire $30,000 goes to preferred shareholders (\( \frac{30,000}{15,000} = 2\) dollars per preferred share), leaving the preferred dividend arrears as \(45,000 - 30,000 = 15,000\) dollars. There are no dividends for common stock.

Step 3: Distribute Second Year Dividend

In the second year, \(42,000 is distributed. The arrears from the first year (\)15,000) need to be paid first. With \(42,000 available, pay off \)15,000 arrears first and then \(27,000 for the current year's preferred dividend, which is less than the \)45,000 requirement. This results in a \(18,000 deficit (\)45,000 - $27,000) remaining. Preferred stock receives \( \frac{42,000}{15,000} = 2.8\) dollars per share. No dividends for common stock.

Step 4: Distribute Third Year Dividend

In the third year, \(90,000 is distributed. First, cover the \)18,000 preferred stock deficit remaining from the previous years. Then, pay the \(45,000 preferred dividend. This amounts to \)63,000 for preferred. Thus, \( \frac{63,000}{15,000} = 4.2\) dollars per preferred share. The remaining $27,000 goes to common stock, so \( \frac{27,000}{50,000} = 0.54\) dollars per common share.

Step 5: Distribute Fourth Year Dividend

In the fourth year, \(120,000 is distributed. Pay the full \)45,000 preferred dividend for the current year. Preferred stockholders get \( \frac{45,000}{15,000} = 3\) dollars per share. The remaining $75,000 is distributed to common stockholders, so \( \frac{75,000}{50,000} = 1.5\) dollars per common share.

Step 6: Summary of Dividends Per Share

Summarizing dividends per share for each year: - Year 1: Preferred = $2, Common = $0 - Year 2: Preferred = $2.8, Common = $0 - Year 3: Preferred = $4.2, Common = $0.54 - Year 4: Preferred = $3, Common = $1.5

Key Concepts

Preferred Stock Dividends

Preferred stockholders receive dividends at a fixed rate, which takes precedence over common stock dividends. In the case of Fairmount Inc., the preferred stock dividends were calculated based on a dividend rate of 2% on a par value of $150. This means the annual dividend per preferred share was set at $3. To determine the total dividend payout for the preferred stock, multiply the dividend per share by the total number of preferred shares. In this scenario, with 15,000 preferred shares outstanding, the total annual preferred dividends equaled $45,000.

Preferred dividends are typically distributed before any common stock dividends. In the event of limited profits, as was the case in Fairmount's first two operational years, these dividends may not fully meet the total required amount, resulting in accumulated dividends to future years.

Common Stock Dividends

Common stock dividends, unlike preferred dividends, do not have a fixed rate and are paid out from the remaining profits after preferred dividends have been satisfied. In Fairmount's scenario, common stockholders only received dividends in the third and fourth years, once the preferred stock obligations were covered.

For common stock, the dividends per share are calculated by dividing the remaining distributable amount after accounting for the preferred dividends by the total number of common shares. Fairmount had 50,000 shares of common stock, so dividends per share were determined for each year with dividends remaining for common distribution.

Cumulative Dividends

Cumulative dividends are a characteristic of certain preferred stocks, including those held by Fairmount's shareholders. This feature ensures that any unpaid dividends are carried over to future periods until they are fully paid. This means if the annual dividend is not paid in full, the remainder becomes part of a backlog that must be cleared before any common stock dividends are distributed.

In the case study, Fairmount ended its first year with $15,000 in unpaid dividends. These arrears had to be cleared before current year dividend needs were addressed in the subsequent years. This effectively protected preferred stockholders' interests by ensuring that their expected returns are prioritized over common dividends.

Stock Distribution

Stock distribution involves how a company allocates profits to its shareholders in the form of dividends. This distribution can vary depending on the type of stock and the company's financial situation, as evidenced in Fairmount's example. Different classes of stock, such as preferred and common stock, are distributed differently.

In the Fairmount exercise, the preferred dividends were addressed first due to their cumulative nature and priority status. Once all obligations to preferred stockholders were met, any remaining distributable funds were allocated to common stockholders. This reflects a typical hierarchical distribution method used in corporate finance to maintain order and shareholder satisfaction. Such strategic distribution decisions comply with the company's dividend policy and the terms of stock issuance agreements.