You have recently been appointed CEO of Wizard House Ltd., a wholesale distributor of magic supplies. One day your CFO reminds you that next week you will have to make recommendations to the board of directors regarding this years annual dividend. This catches you totally by surprise. Luckily, the CFO was kind enough to provide you with some additional information. He shows you the projected income statement and balance sheet, without the effect of any dividend declaration.

Income Statement:

Sales.............................................................................................................................. 44,000,000

COGS............................................................................................................................. 29,400,000

Gross profit................................................................................................................. 14,600,000

Operating expenses................................................................................................... 6,000,000

Operating income before interest.......................................................................... 8,600,000

Interest expense........................................................................................................ 1,000,000

Income before tax...................................................................................................... 7,600,000

Income tax (30%)....................................................................................................... 2,300,000

Net income.................................................................................................................. 5,300,000

Statement of Financial Position:

Current Assets

Cash.............................................................................................................................. 4,000,000

Accounts receivable.................................................................................................. 5,000,000

Inventory..................................................................................................................... 2,000,000

Other............................................................................................................................ 3,700,000

Total Current Assets.................................................................................................. 14,700,000

Long-term investments............................................................................................. 7,000,000

Property, plant and equipment (net)..................................................................... 17,000,000

Total Assets................................................................................................................. 38,700,000

Current Liabilities

Accounts payable....................................................................................................... 2,000,000

Accrued liabilities....................................................................................................... 3,000,000

Other............................................................................................................................ 4,000,000

Total Current Liabilities............................................................................................. 9,000,000

Non-current liabilities................................................................................................ 16,000,000

Shareholders Equity

Common shares......................................................................................................... 1,000,000

Contributed surplus................................................................................................... 4,900,000

Retained earnings (includes this years net income)........................................... 7,800,000

Total Shareholders Equity........................................................................................ 13,700,000

Total Liabilities and Equity................................................................................................. 38,700,000

Other information:

1) Last year, the net income was $3,500,000, and $3,300,000 cash dividends were paid.

2) Wizard House has two debt agreements that call for the corporation to maintain at least $2,500,000 in retained earnings, as well as maintain a debt-to-total-assets ratio of no more than 70%.

3) There has been no change in the number of shares outstanding during the year.

You start to think about the recommendations you are going to make. It is the end of November, and historically the corporation has declared dividends five days before the end of the year.

Instructions

a) What factors will limit the amount to be distributed as dividends?

b) What are important considerations in your decision? What would you recommend? Provide any journal entry that is related to your decision.