Assume the debt is due. Given that Jones has $10,000 in stockholder\'s equity ca

Question

Assume the debt is due. Given that Jones has $10,000 in stockholder's equity can the company repay the creditors at this point? Why or why not? Based on this information alone, can you determine whether White can pay a $2,000 cash dividend? Why or why not? Reconstruct the accounting equation for each company using percentages on the right side of the equation instead of dollar value. Which company is more financially stable? Why? Assume Allen incurs a $3,500 operating loss. The remaining assets are sold for the value shown on the books, and the cash proceeds are distributed to the creditors and investors. How much money will be paid to creditors and how much will be paid to investors? Assume White incurs a$3,500 operating loss. The remaining assets are sold for the value shown on the books, and the cash proceeds are distributed to the creditors and investors. How much money will be paid to creditors and how much will be paid to investors?

Explanation / Answer

a. Dividends can be paid from - (i) current year's profits or from (ii) previous year's profits or from (iii) reserves.

In this case, retained earnings of White is $1,800. This is less than the amount of dividend of $2,000. As there are no reserves, White's dividend amount cannot exceed its retained earnings of $1,800. This is because it does not have the resource to pay the balance amount of 2,000 - 1,800 = $200.

b. Allen:

White:

White is more stable as it has lower debt and higher proportion of common stock and retained earnings. Its D/E ratio = 3,000/(7200+1800) = 33.33%

Allen's debt equity ratio = 7500/(2000+500) = 300%. Thus, White has a lower D/E ratio, making its balance sheet more leaner and making the company more stable.

(assuming that all the liabilities are in the form of debt).

c. Now Allen has incurred a loss of $3500. This will make the retained earnings as $500 (previous balance) - 3500 (current loss) = -3,000. It is a reduction of $3,500. The company's assets will also decline in value by $3,500 (assuming that the extra expense of 3500 is paid out of cash, thus decreasing Allen's assets by 3500 as well)

Thus its assets will become: 10,000 - 3,500 = 6,500. Liabilities are same as $7,500. Common equity will be $2,000 and retained earnings will be 500 - 3500 = -3,000

Thus its accounting equation will be:

Cash proceeds from the sale of assets = $6,500. As creditors amount is higher than this, the entire amount of $6,500 will be paid to creditors. Net worth of investors here has become negative. Net worth = stock+retained earnings = 2,000 - 3,000 = -1,000. Thus 6,500 will be paid to creditors and nothing will be paid to investors.

d. Similarly, White's loss = 3,500. Its accounting equation will be:

Assets will become = 12,000 - 3,500 = 8500.

Retained earnings will be = previous balance+current loss = 1800-3500 = -1,700

Cash proceeds = $8,500. Of this creditors will be paid off their due of $3,000. Remaining cash = 8500-3000 = 5500.

Investors will have to be paid = common stock+retained earnings = 7200-1700 = 5500. Thus investors will be paid 5500. remaining cash = 5500-5500 = nil.

Assets = Liabilities + Stock + Retained earnings 10,000 7,500 2,000 500 100% 75% 20% 5%

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