Question

Squash Delight Inc. has the following balance sheet:

Assets
Cash	\(100,000
Accounts receivables	\)300,000
Fixed assets	\(600,000
Total assets	\)10,000,000
Liabilities
Accounts payable	\(150,000
Notes payable	\)50,000
Common stock (50,000 shares @\(2 par)	\)100,000
Capital in excess of par	\(200,000
Retained earnings	\)500,000
	\(10,000,000

The firm’s stock sells for \)10 a share.

a. Show the effect on the capital account(s) of a two-for-one stock split.

b. Show the effect on the capital accounts of a 10 percent stock dividend. Part b is separate from part a. In part b, do not assume the stock split has taken place.

c. Based on the balance in retained earnings, which of the two dividend plans is more restrictive on future cash dividends?

Short answer

(a) The capital account will show the same balance, but the number of shares has increased.

(b) The balance of common stock will be $110,000, capital in excess of par will be $240,000, and retained earnings will be $450,000.

(c) The stock dividend plan is more restrictive for future dividends.

Step-by-step solution

Table showing changes in capital account

Common stock (100,000 shares @ $1 par)	$100,000
Capital in excess of par	$200,000
Retained earnings	$500,000

Effect of 10% stock dividend on capital account

The balance of common stock will be $110,000, capital in excess of par will be $240,000, and retained earnings will be $450,000.

Common stock (55,000 shares @ $2 par)	$110,000
Capital in excess of par	$240,000
Retained earnings	$450,000

$\begin{array}{rcl}\text{Addition to capital in excess of par}& =& \text{Additional shares}\times \left(\text{Market price}-\text{Issue price}\right)\\ & =& 5,000\times \left(\$10-\$2\right)\\ & =& 5,000\times \$8\\ & =& \$40,000\end{array}$

$\begin{array}{rcl}\text{New retained earnings balance}& =& \text{Retained earnings}\\ & & -\text{Addition to common stock}\\ & & -\text{Addition to capital in excess of par}\\ & =& \$500,000-\$10,000-\$40,000\\ & =& \$450,000\end{array}$

The dividend plan that is restrictive on future dividends

The stock dividend is restrictive of the future dividends as it reduces the balance of retained earnings, reducing the amount of cash dividend that can be distributed.