In recent years, Redbird Corporation, a small manufacturer of jet skis for the leisure industry, has followed the practice of issuing a 10 percent stock dividend annually. Although the company's net income has been almost $4 million in each of the past
three years, retained earnings have declined from about $10 million to about $6 million. What is the probable motivation for management's decision to issue an annual 10 percent stock dividend? What is the most likely explanation for the decrease in retained earnings? Given your explanation, would stockholders' equity also decrease by a like amount?
Redbird's management probably has several reasons for issuing a stock dividend. An important one is undoubtedly the desire to give stockholders some evidence of the company's success without using cash. This approach conserves cash for the company's growing operations. It is also likely that management wants to communicate that the earnings represented by the stock dividend are now part of the permanent capital of the company. When the stock dividend is issued, an amount is transferred from retained earnings to contributed capital. This explains why retained earnings have decreased by $4 million during a period in which the company has earned $12 million. Stockholders' equity during this period would have increased. Management may also want to reduce the market price of the stock by increasing the number of shares outstanding through these nontaxable distributions to stockholders.
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