Problem 3 - Accounting Principles

Question

Encore Inc. declared an \(\$ 80,000\) cash dividend. It currently has 3,000 shares of \(7 \%, \$ 100\) par value cumulative preferred stock outstanding. It is one year in arrears on its preferred stock. How much cash will Encore distribute to the common stockholders? (a) \(\$ 38,000\). (c) \(\$ 59,000\). (b) \(\$ 42,000\). (d) None.

Step-by-Step Solution

Answer

(a) \$ 38,000.

Step 1: Calculate Annual Preferred Dividend

First, determine the annual dividend for the preferred stock. The formula is: \( \text{Preferred Dividend} = \text{Number of Preferred Shares} \times (\text{Par Value} \times \text{Dividend Rate}) \). Here, it is: \[ 3,000 \times (100 \times 0.07) = 3,000 \times 7 = 21,000 \, \text{dollars} \] This means the annual preferred dividend is \( \$ 21,000 \).

Step 2: Address Arrears for Preferred Dividends

Since the preferred dividends are one year in arrears, Encore needs to pay two years' worth of preferred dividends. This means they need to cover the current year and one year of arrears: \[ 2 \times 21,000 = 42,000 \text{ dollars} \]

Step 3: Subtract Preferred Dividends from Total Dividend Declared

Subtract the total amount needed for preferred dividends from the total declared cash dividends to find how much is left for common stockholders: \[ 80,000 - 42,000 = 38,000 \text{ dollars} \]

Step 4: Determine Cash for Common Stockholders

The amount calculated in Step 3, \( \$ 38,000 \), is the cash that will be distributed to the common stockholders.

Key Concepts

Cash Dividend

A cash dividend is a payment that a company makes to its shareholders from its earnings or profits. The primary motive behind distributing cash dividends is to return a portion of the company's earnings to its investors, rewarding them for their investment. These payouts are usually issued on a regular basis, such as quarterly or annually, and the decision to distribute dividends depends on the company’s board of directors.
In the given exercise, Encore Inc. declared a total cash dividend of $80,000. This means that the company has set aside this amount from its profits to be distributed among its shareholders. It is essential to understand that before making payments to common stockholders, any obligations to preferred stockholders must be fulfilled. This obligation is crucial, especially in the context of cumulative preferred stock.

Arrears

Arrears refer to unpaid or overdue dividends that a company owes to its cumulative preferred stockholders. Cumulative preferred stock ensures that if a company misses or skips dividend payments in any year, those unpaid dividends accumulate and must be paid out in the future before any dividends can be directed towards common stockholders.
In the situation with Encore Inc., the preferred dividends are one year in arrears, which means that the company skipped paying dividends last year. Therefore, for Encore to fulfill its obligation, it must pay both the current year’s preferred dividend and the amount in arrears for the previous year. This concept plays a critical role in determining how much of the cash dividend is available for common stockholders after meeting the obligations to preferred stockholders.

Common Stockholders

Common stockholders are individuals or entities that hold common shares of a company, which represent ownership in a corporation. They are entitled to vote on corporate matters and also have the potential to receive dividends. However, they receive dividends only after the company has fulfilled its obligations to preferred stockholders.
In the context of the exercise, once Encore settles its preferred dividend commitments, any remaining cash dividends are distributed to common stockholders. In this scenario, after accounting for arrears and the current preferred dividends, Encore Inc. distributes $38,000 of the total declared dividends to its common stockholders. This distribution serves as their portion of the earnings shared by the company.

Preferred Dividend Calculation

Calculating preferred dividends is a crucial step in understanding how much a company needs to pay to preferred stockholders before distributing any dividends to common stockholders. This involves understanding the terms of the preferred stock, specifically the dividend rate and par value.
The formula to calculate the annual preferred dividend is: \[ \text{Preferred Dividend} = \text{Number of Preferred Shares} \times (\text{Par Value} \times \text{Dividend Rate}) \] In the exercise, Encore Inc. has 3,000 shares of cumulative preferred stock with a par value of $100 and a dividend rate of 7%. Therefore, the annual dividend is calculated as \[ 3,000 \times (100 \times 0.07) = 21,000 \text{ dollars} \]. Given that the preferred dividends are in arrears for one year, the company must pay a total of two years' worth of dividends: \[ 2 \times 21,000 = 42,000 \text{ dollars} \]. This calculation ensures that preferred stockholders are paid in full before any distributions to common stockholders.