Rainbow Designs Inc. has paid quarterly cash dividends since 1997. These dividends have steadily increased from $0.05 per share to the latest dividend declaration of $0.40 per share. The board of directors would like to continue this trend and is hesitant to suspend or decrease the amount of quarterly dividends. Unfortunately, sales dropped sharply in the fourth quarter of 2010 because of worsening economic conditions and increased competition. As a result, the board is uncertain as to whether it should declare a dividend for the last quarter of 2010.
On November 1, 2010, Rainbow Designs Inc. borrowed $1,200,000 from Washington National Bank to use in modernizing its retail stores and to expand its product line in reaction to its competition. The terms of the 10-year, 6% loan require Rainbow Designs Inc. to:
a. Pay monthly interest on the last day of the month.
b. Pay $120,000 of the principal each November 1, beginning in 2011.
c. Maintain a current ratio (current assets/current liabilities) of 2.
d. Maintain a minimum balance (a compensating balance) of $60,000 in its Washington National Bank account.
On December 31, 2010, $300,000 of the $1,200,000 loan had been disbursed in modernization of the retail stores and in expansion of the product line. Rainbow Designs Inc.€™s balance sheet as of December 31, 2010, is shown below.
The board of directors is scheduled to meet January 5, 2011, to discuss the results of operations for 2010 and to consider the declaration of dividends for the fourth quarter of 2010. The chairman of the board has asked for your advice on the declaration of dividends.
1. What factors should the board consider in deciding whether to declare a cash dividend?
2. The board is considering the declaration of a stock dividend instead of a cash dividend. Discuss the issuance of a stock dividend from the point of view of
(a) A stockholder and
(b) The board ofdirectors.

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Rainbow Designs Inc. Balance Sheet December 31, 2010 Assets Current assets: $ 96,000 Cash. Marketable securities 900,000 Accounts receivable.. $ 219,600 15,600 204,000 Less allowance for doubtful accounts Merchandise inventory . Prepaid expenses. 300,000 10,800 $1,510,800 Total current assets. Property, plant, and equipment: $ 360,000 Land.. Buildings . $2,280,000 516,000 Less accumulated depreciation. 1,764,000 Equipment.. $1,104,000 264,000 Less accumulated depreciation .. 840,000 Total property, plant, and equipment. 2,964,000 $4,474,800 Total assets Liabilities Current liabilities:. Accounts payable.. Notes payable (Washington National Bank) $ 172,320 120,000 Salaries payable... 7,680 $ 300,000 Total current liabilities.. Long-term liabilities: Notes payable (Washington National Bank) 1,080,000 $1,380,000 Total liabilities . Stockholders' Equity Paid-in capital: Common stock, $20 par (100,000 shares authorized, 60,000 shares issued) Excess of issue price over par $1,200,000 96,000 Total paid-in capital. . Retained earnings $1,296,000 1,798,800 Total stockholders' equity.. 3,094,800 $4,474,800 Total liabilities and stockholders' equity..