In states where the firms legal capital includes all

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Unformatted text preview: is defined as the par value of its common stock, the firm could pay out $340,000 ($200,000 $140,000) in cash dividends without impairing its capital. In states where the firm’s legal capital includes all paid-in capital, the firm could pay out only $140,000 in cash dividends. CHAPTER 13 Dividend Policy 567 An earnings requirement limiting the amount of dividends is sometimes imposed. With this restriction, the firm cannot pay more in cash dividends than the sum of its most recent and past retained earnings. However, the firm is not prohibited from paying more in dividends than its current earnings.4 EXAMPLE excess earnings accumulation tax The tax the IRS levies on retained earnings above $250,000 when it determines that the firm has accumulated an excess of earnings to allow owners to delay paying ordinary income taxes on dividends received. Assume that Miller Flour Company, from the preceding example, in the year just ended has $30,000 in earnings available for common stock dividends. As the preceding table indicates, the firm has past retained earnings of $140,000. Thus it can legally pay dividends of up to $170,000. If a firm has overdue liabilities or is legally insolvent or bankrupt, most states prohibit its payment of cash dividends. In addition, the Internal Revenue Service prohibits firms from accumulating earnings to reduce the owners’ taxes. If the IRS can determine that a firm has accumulated an excess of earnings to allow owners to delay paying ordinary income taxes on dividends received, it may levy an excess earnings accumulation tax on any retained earnings above $250,000. Contractual Constraints Often the firm’s ability to pay cash dividends is constrained by restrictive provisions in a loan agreement. Generally, these constraints prohibit the payment of cash dividends until a certain level of earnings has been achieved, or they may limit dividends to a certain dollar amount or percentage of earnings. Constraints on dividends help to protect creditors from losses due to the firm’s insolvency. Internal Constraints The firm’s ability to pay cash dividends is generally constrained by the amount of liquid assets (cash and marketable securities) available. Although it is possible for a firm to borrow funds to pay dividends, lenders are generally reluctant to make such loans because they produce no tangible or operating benefits that will help the firm repay the loan. EXAMPLE Hint Firms that grow very rapidly, such as hightech firms, cannot afford to pay dividends. Their stockholders are influenced by the possibility of exceptionally higher share price and dividend levels in the future. Miller Flour Company’s stockholders’ equity account presented earlier indicates that if the firm’s legal capital is defined as all paid-in capital, the firm can pay $140,000 in dividends. If the firm has total liquid assets of $50,000 ($20,000 in cash plus marketable securities worth $30,000) and $35,000 of this is needed for operations, the maximum cash dividend the firm can pay is $15,0...
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