Fundamental Accounting Principles
Fundamental Accounting Principles
24th Edition
ISBN: 9781259916960
Author: Wild, John J., Shaw, Ken W.
Publisher: Mcgraw-hill Education,
Question
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Chapter 13, Problem 5BTN
To determine

Concept Introduction:

Common Stockholder: Common stockholders are considered as the owner of the company but when it comes to dividend, they come after preference stockholders.

Cumulative Preferred Stock: Preference stockholders are preferred first at the time of distribution of dividend. The dividends on cumulative preference stock are fixed and compulsory and if it not paid, it accumulates over the years.

Requirement 1:

If the new business is expected to earn $72,000 of after-tax net income in the first year, what rate of return on beginning equity will the founder earn under each alternative plan? Which plan will provide the higher expected return?

Expert Solution
Check Mark

Answer to Problem 5BTN

Plan B provides higher rate of return.

    Return on beginning equityAmount Rate
    Plan A$57,60015.36%
    Plan B$62,00016.53%

Explanation of Solution

Plan A: (Issue of 3,750 common stock)

  Return on equity =  Net Income after Tax × Beginning Equity *  Ending Equity                            =  $72,000 ×15,000   18,750                            = $57,600Rate of Return on Equity =  $57,600   $375,000 × 100                                         = 15.36% *Ending Equity = 15,000 shares + 3,750 shares = 18,750 shares

Plan B: (Issue of 1,250 cumulative preferred stock)

   Return on equity = Net Income after Tax  Preferred Dividend                             = $72,000  $10,000                             = $62,000 Rate of Return on Equity =  $62,000   $375,000  × 100                                          = 16.53%

To determine

Concept Introduction:

Common Stockholder: Common stockholders are considered as the owner of the company but when it comes to dividend, they come after preference stockholders.

Cumulative Preferred Stock: Preference stockholders are preferred first at the time of distribution of dividend. The dividends on cumulative preference stock are fixed and compulsory and if it not paid, it accumulates over the years.

Requirement 2:

Compute the rate of return under each alternative, if the net income after tax is $16,000 and determine which plan results in higher expected return?

Expert Solution
Check Mark

Answer to Problem 5BTN

Plan A provides higher rate of return.

    Return on beginning equityAmount Rate
    Plan A$13,4403.58%
    Plan B$6,8001.81%

Explanation of Solution

Plan A: (Issue of 3,750 common stock)

  Return on equity =  Net Income after Tax × Beginning Equity *  Ending Equity                            =  $16,800 × 15,000   18,750                            = $13,440Rate of Return on Equity =  $13,440    $375,000× 100                                         = 3.58%*Ending Equity = 15,000 shares + 3,750 shares = 18,750 shares

Plan B: (Issue of 1,250 cumulative preferred stock)

  Return on equity = Net Income after Tax  Preferred Dividend      = $16,800  $10,000                            = $6,800Rate of Return on Equity = $6,800  $375,000 × 100                                         = 1.81%

To determine

Concept Introduction:

Cumulative preference shares: The preference share on which payment of dividend is compulsory, otherwise accumulates over the year is called cumulative preference shares. The rate of dividend on preference shares are fixed like interest expense on debt funds.

Requirement 3:

Analyze and interpret the difference between the results for parts 1 and 2.

Expert Solution
Check Mark

Answer to Problem 5BTN

Considering the results for part 1, the plan B results in higher rate of return but results for part 2 shows a higher rate of return in plan B. Here the amount of net income after tax is a key factor in determining the rate of return on beginning equity if the founder. When it is high, it is favorable for plan A because the preference dividend is easily covered and there is less number of stockholders. But when the net income is low, the preference dividend becomes a burden and there is less amount of income to be distributed among the shareholders.

Explanation of Solution

The 8% dividend on cumulative preferred stock is fixed charge which the company has to pay whether they earn profit or incurred loss. On the other hand, issue of common stock results in increase of number of stockholders to whom dividends will be distributed which means decrease in earnings per share.

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Chapter 13 Solutions

Fundamental Accounting Principles

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