Kennington Company has outstanding debt that contains restrictive covenants limiting dividends to 15 percent of net income from continuing operations. During 2018, the company reported net operating income of $335,000, excluding the following items—all of which ignore tax effects:
1. A $25,000 gain was recognized on the sale of an investment.
2. A $62,000 contingent loss was recognized on a lawsuit.
3. A $38,000 loss was recognized on the early retirement of debt.
Assume that the gain in (1) is taxable, the losses in (2) and (3) are tax deductible, and the company’s tax rate is 35 percent.
a. Provide the income statement, beginning at net income from operations, and compute the maximum amount of dividends that the company can declare, assuming that (1) the investment in (1) is a business segment that broke even during 2018 and (2) lawsuits are common for Kennington.
b. Provide the income statement, beginning at net income from operations, and compute the maximum amount of dividends that the company can declare, assuming that (1) the investment in (1) is a short-term equity security and (2) lawsuits are very rare for Kennington.