Question

Suppose Care-4-You Hospital has two million dollars of net income remaining at the end of 201x. The financial managers must decide whether to retain all the earnings or pay a dividend to stockholders.

Suppose you are a financial manager at Care-4-You Hospital. You discover that a new piece of equipment costing $1 million would allow the hospital to expand its services. In two years, the hospital would recover all initial costs of the machine. As the financial manager, would you recommend purchasing the equipment? Why or why not? What impact does your decision have on the hospital, the stockholders and other users of financial information?   (8 points)

Answer 1

Care-4-You Hospital has $2 million in net income which it can either distribute to shareholders as dividends or retain the earnings for future growth opportunities.

If $1 million investment in new equipment would allow the hospital to expand its services I would recommend purchasing it. The payback period (2 years) in this case is shorter too. Also, because retained earnings is the cheapest source of funding projects/investments.

Since, you can either retain all the earnings or pay dividends in this case we would retain entire $2 million and invest $1 million on new piece of equipment. Remaining earnings will form a part of retained earnings and can be utilized for future opportunities.

Sometimes, companies distribute a part of net income as dividends and retain the remaining amount. Same can be done here. $1 million can be invested on new equipment and the rest can be distributed as dividends.

Reduction in dividends or dividend discontinuation in isolation can be viewed as a negative sign by shareholders. It is perceived as if the company's future is bleak.

But if management can justify the reduction or discontinuation in dividends then shareholders can view it as a positive signal. In this case it can be viewed as a positive signal as investing the profits on new piece of equipment will help the hospital to expand its services.