Question

Suppose Care-4-You Hospital has two million dollars of net income remaining at the end of 201x. The financial managers must decide whether to retain all the earnings or pay a dividend to stockholders. 1. If the financial managers pay dividends to stockholders in the amount of one million dollars (half of the net income amount), what effect does this have on the statement of retained earnings? What account(s) would be affected? (4 points) 2. Discuss the advantages or disadvantages of retaining the money in the business versus paying a dividend to the stockholders. (5 points) 3. Suppose you are a financial manager at Care-4-You Hospital. You discover that a new piece of equipment costing $1 million would allow the hospital to expand its services. In two years, the hospital would recover all initial costs of the machine. As the financial manager, would you recommend purchasing the equipment? Why or why not? What impact does your decision have on the hospital, the stockholders and other users of financial information? (8 points)

Answer 1

1. Dividends are payments a corporation makes to its shareholders as a return of company's profits. Dividends are often paid quarterly, but may also be paid annually or semi-annually. Retained earnings, an equity account found on the company's balance sheet, is reduced at the time the dividends are declared.

Retained earnings is an equity account that comprises balance of company's earnings accumulated over time (remaining "retained" or undistributed). The account is shown as a line item on the company's balance sheet in the owners' or shareholders' equity section, and its balance is used to be reinvested in the company.

When the company issues, or "declares" dividends, the accounting effect is a reduction in the retained earnings balance and an increase in the liability account "dividends payable." When the dividends are paid, the liability is removed from the company's books and the cash balance is reduced.

2. Pay Dividends-

Advantages:

• Sends message about a company's future prospects and performance.
• Solid demonstration of financial strength
• Makes stock attractive - investors would want to invest more in dividend paying companies
• Increase stock price owing to more demand

Retain Earnings-

Advantages:

• Reinvest cash back into operations / fund new initiatives which can spike stock price
• No need to pay tax - Non-qualified dividends are taxable to investors as ordinary income - at marginal rates
• Capital gains on appreciated stock can low long-term capital gains tax rate (if held for a year)

3. Since the inflows from the new equipment shall be $0.5 mn ($1mn /2) as against the depreciation of $0.2 mn (depreciated over 5 years), the net income of the hospital shall increase by $0.3mn. Hence would recommend the hospital to buy the equipment.