4. You are considering purchasing the preferred stock of a firm but are concerne
ID: 2663898 • Letter: 4
Question
4. You are considering purchasing the preferred stock of a firm but are concerned about its capacity to pay the dividend. To help allay that fear, you compute the times-preferred-dividend-earned ratio for the past three years from the following data taken from the firm’s financial statements:
Year- X1 X2 X3
Operating income - $12,000,000 $15,000,000 $17,000,000
Interest- 3,000,000 5,900,000 11,000,000
Taxes- 4,000,000 5,400,000 4,000,000
Preferred dividends- 1,000,000 1,000,000 1,500,000
Common dividends- 3,000,000 2,000,000 -
What does your analysis indicate about the firm’s capacity to pay preferred stock dividends?
Explanation / Answer
The formula for calculating the Times Preferred Dividend earned ratio is
Times preferred Dividend Earned ratio = Net income Available to preferred / Annual preferred dividend Requirements
Net income in the Year X1:
Operating expenses $12,000,000
(-) Interest $3,000,000
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Income before taxes $9,000,000
(-) Taxes $4,000,000
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Net income $5,000,000
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Therefore, the Times Preferred Dividend earned for X1 is
Times preferred Dividend Earned = Net income / Annual Preferred Dividend
= $5,000,000 / $1,000,000
= 5 times
Net income for X2:
Operating expenses $15,000,000
(-) Interest $5,900,000
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Income before taxes $9,100,000
(-) Taxes $5,400,000
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Net income $3,700,000
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Therefore, the Times preferred Dividend Earned for x2 is
= $3,700,000 / $1,000,000
= 3.7
Calculating Net income for X3:
Operating expenses $17,000,000
(-) Interest $11,000,000
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Income before taxes $6,000,000
(-) Taxes $4,000,000
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Net income $2,000,000
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Therefore, the Times preferred Dividend earned for X3 is
= $2,000,000 / $1,500,000
= 1.33
Therefore, according to the calculated values of Times preferred Dividend earned, the company's ability to pay dividends has came dowm from year X1 to X3. This inicates that the company is losing capacity to pay dividends which is the most important yield to preferred shareholders.
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