Pay Dividends or Grow the Business?

Accounting for Companies Limited by Shares

Skill: Evaluate

Stimulus

Question

(a) Calculate the total dividend payment for Proposal A and Proposal B, and the cash balance remaining after each.

(b) Evaluate both proposals and recommend which one the board should choose. Justify your answer based on the cash position, expansion needs, and shareholders' interests.

Thinking steps

1. Identify that the preference dividend must be paid first: 6% x RM100,000 = RM6,000 under both proposals.
2. Compute the full cost of each proposal and compare it against the RM50,000 cash balance, not just the RM90,000 retained profit.
3. Test each proposal against operating cash needs and the plan to buy the RM40,000 machine.
4. Weigh the trade-off: immediate dividends for ordinary shareholders versus liquidity and long-term growth.
5. Make a clear decision and support it with at least two justifications grounded in the figures and their effects.

Model answer

Calculation:

Preference dividend = 6% x RM100,000 = RM6,000 (paid first under both proposals).

Proposal A: Ordinary dividend = RM0.10 x 400,000 shares = RM40,000. Total dividend = RM6,000 + RM40,000 = RM46,000. Cash left = RM50,000 - RM46,000 = RM4,000.

Proposal B: Only the preference dividend of RM6,000. Cash left = RM50,000 - RM6,000 = RM44,000; after buying the RM40,000 machine, cash left = RM4,000.

Evaluation and decision:

I recommend the board choose Proposal B.

Justification (i) Use of cash: Both proposals leave the same RM4,000 of cash, but they use the other RM46,000 differently. Under A, it is paid out to shareholders; to buy the machine as well, the company would have to borrow RM36,000 (RM40,000 - RM4,000). Under B, RM40,000 stays in the business as a productive asset, with no new debt.

Justification (ii) Growth: Proposal A leaves no room to buy the RM40,000 machine, so the expansion plan stalls. Proposal B funds the machine, raising production capacity and future profit potential.

Justification (iii) Shareholders' interest: Although ordinary shareholders receive no dividend under Proposal B (its weakness), the retained profit and the machine investment increase the company's value and its ability to pay higher dividends next year. The decision prioritises long-term sustainability over an immediate reward that stalls expansion.