income taxes must be $4,480,000 calculated as follows: Notation: NI = Net Income. PD = Preferred Dividends. CD = Common
Hamilton Plastics – Dividends 1. In order to meet the specified requirements, Hamilton Plastics’ earnings before interest and income taxes must be $4,480,000 calculated as follows: Notation: NI = Net Income PD = Preferred Dividends CD = Common Dividends CP = Capital Projects Net income must be sufficient to cover preferred dividends, common dividends, and capital projects (NI = PD + CD + CP). •
Preferred dividends are cumulative, but they are not in arrears. Therefore, only the current preferred dividend needs to be paid before any dividend on common stock can be paid. PD = $3,000,000 x .09 = $270,000
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Common dividends equal 25 percent of net income. Therefore, CD = .25 NI
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Capital projects aggregate $1,530,000. Therefore, CP = $1,530,000
Therefore, NI = PD + CD + CP = $270,000 + .25NI + $1,530,000 = $2,400,000 Earnings before income tax [$2,400,000 + (1 - .4)] Interest ($6,000,000 x .08) Earnings before interest and income taxes
$4,000,000 480,000 $4,480,000
2. The advantages of a steady dividend policy include: •
Steady dividends provide informational content, i.e., dividends may serve to resolve uncertainty in the minds of investors, reducing risk. When earnings drop and a company maintains its dividend, the market may have more confidence in the stock than if the dividend were cut. The stable dividend may convey management’s view that the future of the company is better than the drop in earnings suggests.
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Stocks with a steady dividend stream supported by earnings (not by debt or other stock issues) tend to have higher prices that enhance the firms’ ability to finance future requirements through equity issues.
The disadvantages of a steady dividend policy include: •
Deviations from steady dividend trends can cause sudden movements in the market price of the firm’s stock.
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Firms that do not have the cash available may be forced to borrow to meet dividend commitments. Dividends financed with debt or equity change the financial structure of the firm.
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Pressure to maintain a steady dividend policy minimizes management’s flexibility in utilizing cash resources.
