John Pepmeier, your longtime friend, owns 2,000 shares of $1 par value common stock in Sports Stuff Inc. There are 1,000,000 shares of common stock authorized, and 800,000 shares are issued and outstanding. Recently, the company was authorized to issue 200,000 shares of $50 par value preferred stock. These shares have a dividend rate of 8 percent based on par value, and they are cumulative. The company expects to sell 10,000 shares of the preferred stock in the near future to finance the acquisition of more production facilities. John has studied the firm’s annual reports in an effort to determine the impact the new stock issue will have on his dividends. He is confused because his $1 par value common stock has a market value of $50 per share. He has received a $5 dividend per share in recent years. The company has consistently maintained a policy of paying out 70 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, John is concerned that the company will not make enough net income to maintain his $5 per share dividend.
A. Explain to John in memo form the difference between par value and market value.
B. Show John how to compute the minimum amount of after-tax net income the company must earn for him to receive a $5 per share dividend if the 10,000 shares of preferred stock are sold.
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