Question

Read the discussion questions below, select one, and post a comment of at least 150 words. After you have posted your answer, post at least 2 responses to your classmates' answers.

If a "typical" firm reports $20 million of retained earnings on its balance sheet, could its directors declare a $20 million cash dividend without any qualms whatsoever? Explain why or why not?

Answer 1

The declaration of dividends is at the discretion of the management. In any circumstance the amount of dividends cannot exceed the amount of retained earnings of the business. In this scenario the business has $20,000,000 worth of retained earnings on its balance sheet. The directors can declare this as the maximum amount of dividend. However they need to keep in mind certain points.

Firstly declaring the entire amount of retained earnings as dividend will wipe off a substantial portion of the equity. This will increase the risk of the firm since its debt-equity ratio will increase substantially. Reliance on higher debt will increase the risk of the firm and this will increase the weighted average cost of capital of the business. This will have a major impact on the share price. Moreover, the company will not have any retained earnings to invest in any of the projects which will yield greater returns for the business.