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Difficulty: Very hardEquity Securities and Characteristics

Vanguard Logistics Corp. has 1,000,0001,000,000 shares of common stock outstanding and 100,000100,000 shares of $100\$100 par value, 6%6\% cumulative convertible preferred stock. The company suspended all dividend payments for the previous two consecutive years due to temporary cash flow constraints. In the current fiscal year, the board of directors approves a total cash dividend pool of $2,400,000\$2,400,000 to be paid prior to launching a preemptive rights offering for new common shares. Assuming no preferred shares have been converted into common stock, which of the following accurately describes the dividend distribution hierarchy and rights of the equity holders?

  1. Preferred shareholders must receive a total payout of $1,800,000\$1,800,000 before any dividends are paid to common shareholders, leaving $600,000\$600,000 available for distribution to common equity holders.Answer
  2. B
    Preferred shareholders are entitled to vote alongside common shareholders regarding the authorization of the upcoming preemptive rights offering because convertible status grants full corporate voting privileges.
  3. C
    Common shareholders receive the entire $2,400,000\$2,400,000 distribution because dividends in arrears on preferred stock represent unsecured debt liabilities that are settled only during corporate liquidation.
  4. D
    Common shareholders who exercise their preemptive rights in the upcoming subscription offering will eliminate market risk associated with holding equity securities in Vanguard Logistics Corp.

Answer

Cumulative preferred shareholders must be paid $1,800,000\$1,800,000 (representing two years of dividends in arrears plus the current year obligation) prior to common shareholders receiving the remaining $600,000\$600,000 of the dividend pool.
Cumulative preferred stock requires all previously omitted dividends (dividends in arrears) plus the current period dividend to be paid in full before any distribution can be made to common shareholders. With an annual obligation of $600,000\$600,000, two years of arrears equal $1,200,000\$1,200,000, which combined with the current year's $600,000\$600,000 creates a $1,800,000\$1,800,000 priority payout to preferred shareholders, leaving $600,000\$600,000 for common shareholders.

Step-by-Step Solution

1
Calculate annual preferred dividend requirement.
Annual Dividend=100,000 shares×$100 par×6%=$600,000\text{Annual Dividend} = 100,000 \text{ shares} \times \$100 \text{ par} \times 6\% = \$600,000.
Determines the base yearly dividend obligation for preferred equity holders.
2
Calculate total preferred dividends owed including arrears.
Arrears=2 years×$600,000=$1,200,000\text{Arrears} = 2 \text{ years} \times \$600,000 = \$1,200,000; Total Preferred Owed=$1,200,000 (arrears)+$600,000 (current year)=$1,800,000\text{Total Preferred Owed} = \$1,200,000 \text{ (arrears)} + \$600,000 \text{ (current year)} = \$1,800,000.
Cumulative preferred stock mandates full settlement of passed dividends before common equity receives distributions.
3
Determine the remaining dividend allocation for common equity.
Common Shareholder Allocation=$2,400,000 (total pool)−$1,800,000=$600,000\text{Common Shareholder Allocation} = \$2,400,000 \text{ (total pool)} - \$1,800,000 = \$600,000.
Common shareholders act as residual claimants on corporate income distributions.

Key Concept

Cumulative Preferred Dividend Priority and Common Stock Preemptive Rights Characteristics
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Topics

Equity Securities and Characteristics

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