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Financial & Managerial Accounting

14th Edition
Carl Warren + 2 others
ISBN: 9781337119207

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BuyFindarrow_forward

Financial & Managerial Accounting

14th Edition
Carl Warren + 2 others
ISBN: 9781337119207
Textbook Problem

Communication

Motion Designs Inc. has paid quarterly cash dividends since 20Y7. These dividends have steadily increased from $0.05 per share to the latest dividend declaration of $0.50 per share. The board of directors would like to continue this trend and is hesitant to suspend or decrease the amount of quarterly dividends. Unfortunately, sales dropped sharply in the fourth quarter of 20Y8 due to worsening economic conditions and increased competition. As a result, the board is uncertain as to whether it should declare a dividend for the last quarter of 20Y8.

On October 1, 20Y8, Motion Designs Inc. borrowed $4,000,000 from Valley National Bank to use in modernizing its retail stores and to expand its product line in response to changes in its industry. The terms of the 10-year, 6% loan require Motion Designs to:

  • Pay monthly interest on the last day of the month.
  • Pay $400,000 of the principal each October 1, beginning in 20Y9.
  • Maintain a current ratio (current assets ÷ current liabilities) of 2.
  • Maintain a minimum balance (a compensating balance) of $100,000 in its Valley National Bank account.

On December 31, 20Y8, $1,000,000 of the $4,000,000 loan had been disbursed in modernization of the retail stores and in expansion of the product line. Motion Designs Inc.’s balance sheet as of December 31, 20Y8, follows:

images

The board of directors is scheduled to meet January 10, 20Y9, to discuss the results of operations for 20Y8 and to consider the declaration of dividends for the fourth quarter of 20Y8. The chairman of the board, Lord Matt Cengage, has asked for your advice on the declaration of dividends.

Write a brief memo to the chairman of the board, outlining the factors that the board should consider in deciding whether to declare a cash dividend.

To determine

Cash dividends: The amount of cash provided by a corporation out of its distributable profits to its shareholders as a return for the amount invested by them is referred as cash dividends.

To write: A memo to the chairman of the board of Incorporation MD, explaining the factors before deciding whether to declare a cash dividend for the last quarter of 20Y8.

Explanation

Write a memo to the chairman of the board of Incorporation MD, explaining the factors before deciding whether to declare a cash dividend for the last quarter of 20Y8.

Memo

To,

Person LMC

The chairman of the board of directors

Incorporation MD

From,

Student A

Respected sir,

It is my pleasure to explain the factors before deciding on whether to declare a cash dividend for the last quarter of 20Y8.

Cash dividends have to be distributed out of retained earnings balance. So, first it is necessary that company should have enough balance of $90,000 (180,000 shares ×$0.50 per share) in retained earnings account to declare the cash dividend. As on December 31, 20Y8, Incorporation MD’s balance in retained earnings is $4,630,000. Retained earnings balance of $4,630,000 is more than enough to cover the declaration of $90,000 cash dividend in total.

After declaration of cash dividend, Incorporation MD should have sufficient cash balance to pay the cash dividend as declared. As on December 31, 20Y8, Incorporation MD’s balance in cash account is $250,000, out of which $100,000 has to be maintained as minimum cash balance as per loan agreement with bank.  Thereby, Incorporation MD can use remaining balance of ($250,000$100,000) $150,000 cash. Now, it is questionable that unless the cash balance can be expected to increase in near future, whether the company’s cash balance is large enough to manage both the payment of cash dividend and day-to-day operations of the business.

As well as, it is necessary to look into the working capital and the effect of plant expansion on the current ratio requirement of the loan

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