Compute the minimum amount of after-tax net income

Suzie Lee, your long-time friend, owns 1,000 shares of $1 par value common stock in Electronics, Inc. There are 1,000,000 shares of common stock authorized, and 100,000 shares are issued and outstanding. Recently, the company was authorized to issue 20,000 shares of $50 par value preferred stock. These shares have a dividend rate of 6 percent based on par, and they are cumulative. The company expects to sell 5,000 shares of the preferred stock in the near future to finance the acquisition of more production facilities. Suzie has studied the company’s annual reports in an effort to determine the effects the new stock issue will have on her dividends. She is confused because her $1 par value common stock has a market value of $32 per share. She has received a $4 dividend per share in recent years. The company has consistently maintained a policy of paying out 60 percent of its after-tax net income as dividends, a policy management expects to continue into the foreseeable future. Aside from being confused about the difference between par value and market value, Suzie is concerned that the company will not make enough net income to maintain her $4 per share dividend.

Required:

A. Explain to Suzie in memo form the difference between par value and market value.

B. Show Suzie how to compute the minimum amount of after-tax net income the company must earn in order for her to receive a $4 per share dividend if the 5,000 shares of preferred stock are sold.

C. Would you recommend that Suzie keep the stock?

Solution: