Problem 1 - Accounting

Question

Fiji Inc., a developer of radiology equipment, has stock outstanding as follows: 25,000 shares of \(1 \%\) nonparticipating, cumulative preferred stock of \(\$ 100\) par, and 250,000 shares of \(\$ 50\) par common. During its first five years of operations, the following amounts were distributed as dividends: first year, none; second year, \(\$ 40,000\); third year, \(\$ 80,000\); fourth year, \(\$ 120,000\); fifth year, \(\$ 140,000\). Calculate the dividends per share on each class of stock for each of the five years.

Step-by-Step Solution

Answer

Preferred dividends are $1 per share when paid; common dividends vary, reaching $0.46 per share by year five.

Step 1: Understand Preferred Stock Dividends

Fiji Inc. has 25,000 shares of 1% nonparticipating, cumulative preferred stock with a $100 par value. This means each preferred share should receive dividends annually at 1% of $100, which equals $1 per share. For all 25,000 preferred shares, this amounts to $25,000 annually. However, since the preferred stock is cumulative, any unpaid dividends must be paid in future years.

Step 2: Calculate Preferred Stock Dividends for the First Year

In the first year, no dividends were paid. Thus, $25,000 of unpaid dividends carries over to the next year.

Step 3: Calculate Preferred Stock Dividends for the Second Year

In the second year, a total of $40,000 was paid in dividends. First, cover the previous year's unpaid preferred dividends of $25,000. The remaining $15,000 is still needed for the current year's preferred dividends. So, only $15,000 is available for the second year's preferred dividends, falling short by $10,000. Thus, $10,000 carries over.

Step 4: Calculate Preferred Stock Dividends for the Third Year

Third year distribution was $80,000. From this, cover the $10,000 arrears from the previous year. Then pay the current year preferred dividends of $25,000, totaling $35,000, which leaves $45,000 for common stock.

Step 5: Calculate Preferred Stock Dividends for the Fourth Year

Fourth year distribution was $120,000. Pay $25,000 for the current year preferred dividends, leaving $95,000 for common stock.

Step 6: Calculate Preferred Stock Dividends for the Fifth Year

Fifth year distribution was $140,000. Pay $25,000 for the current year preferred dividends, leaving $115,000 for common stock.

Step 7: Derive Common Stock Dividends

Based on the remaining amounts after preferred dividends are covered each year: Common stock receives $0 in year one, $0 in year two, $45,000 in year three, $95,000 in year four, and $115,000 in year five.

Step 8: Calculate Dividends Per Share

For preferred shares, the dividend per share is constant at $1 when paid. For common shares, divide the total distributed by 250,000 shares: $0 in years one and two, $0.18 in year three, $0.38 in year four, and $0.46 in year five.

Key Concepts

Preferred Stock

Preferred stock is a type of equity security that comes with certain ownership privileges compared to common stock. Holders of preferred stock often receive dividend payments before any dividends are paid to common stockholders. These shares have a fixed dividend rate, represented as a percentage of the par value.
Let's break it down for Fiji Inc.: they have issued 25,000 shares of preferred stock with a 1% dividend rate and a $100 par value. This means each share is entitled to a $1 dividend annually. However, preferred stocks like these can have features such as being cumulative or nonparticipating, which alter how dividends are handled and paid.
Here's what you need to remember about preferred shares:

• Fixed Dividend: They receive a set dividend amount yearly.
• Priority: They get paid before common shareholders.
• Terms: They can be "+cumulative" or "nonparticipating," which influences their payout.

Common Stock

Common stock represents ownership in a company and a claim to a portion of the company’s profits, typically through dividends. Unlike preferred stock, dividends on common stock are not fixed and can fluctuate based on the company’s profitability.
For Fiji Inc., common shareholders number 250,000 and hold shares with a $50 par value. These shareholders are situated behind preferred shareholders in the pecking order of dividend payments, meaning they receive dividends only after all preferred dividends have been satisfied.
Here's what defines common stocks:

• Variable Dividends: Unlike preferred stocks, dividends can vary each period.
• No Priority: They are paid after preferred stockholders.
• Voting Rights: Often, common stockholders have voting rights in company decisions.

Cumulative Dividends

Cumulative dividends are a key feature of certain preferred stocks. If a company does not pay dividends in a particular year, they accumulate and are paid out before any dividends can be given to common shareholders in future years.
In the case of Fiji Inc., when the company did not distribute dividends in the first year, the $25,000 meant for preferred dividends carried over to the next year. This cumulative nature protects preferred shareholders by ensuring that they eventually receive their due payment.
Key aspects of cumulative dividends include:

• Carryover: Unpaid dividends are added up and must be cleared before any common dividends can be paid.
• Security: Provides a safety net for preferred investors.
• Visibility: Makes companies more accountable for paying dividends to preferred shares before common shares.

Non-participating Stock

Non-participating stock is another feature that can apply to preferred stocks, indicating that shareholders are only entitled to receive fixed dividend payments and nothing more. Unlike participating stocks, which might allow shareholders to earn additional dividends if the company has surplus profits, non-participating stocks do not permit this.
For Fiji Inc.’s preferred stock, labeled as "non-participating," this means even if the company had extra profits after paying the fixed 1% dividends, preferred stockholders would not receive more than their fixed rate.
The main points regarding non-participating stocks are:

• Fixed Income: Shareholders receive no more than the agreed-upon dividend.
• Profit Limits: They cannot share in excess profits beyond their fixed dividend.
• Predictability: While this can limit earnings, it also offers predictable returns.