Total dividends include the dividends on both common shares and preferred shares. The common stock dividends were $1,450,000 × 25% = $362,500. As the cumulative preferred dividends must be paid before the common dividends are paid, they are also included into computation. Since the cumulative preferred dividends were not paid or declared in the previous period, two years worth of cumulative preferred dividends must be paid in the current period before any common dividends can be paid. The amount due for the cumulative preferred dividend is: 5,000 shares × $100 par value × 6% × 2 years = $60,000. So, the total dividends to be paid are $362,500 + $60,000 = $422,500.
This answer results from subtracting the preferred dividend to be paid ($60,000) from net income before calculating the amount of the common dividend to be paid. The problem says that the company wishes to pay common shareholders a dividend equivalent to 25% of net income, not 25% of net income reduced by the dividend to be paid to preferred shareholders. Note that net income minus the cumulative preferred dividend paid is not income available to common shareholders. When there is cumulative preferred stock, income available to common shareholders is calculated by subtracting from net income the cumulative preferred dividends earned , whether or not those dividends were paid. Furthermore, even if net income minus the cumulative preferred dividends paid were the correct way to calculate income available to common shareholders, income available to common shareholders is used only for calculating earnings per share, not for calculating the amount to pay to common shareholders as a dividend.
This answer includes only 1 year of the cumulative preferred dividend. Because the cumulative preferred dividend was not declared in the previous year, the calculation needs to include 2 years of cumulative preferred dividends.
This is the amount of the common stock dividend and excludes the preferred stock dividend. See the correct answer for a complete explanation.
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