Question

You own 100 shares of stock of unlevered Gamma Company which has 1000 shares outstanding. Gamma plans to pay $2,200 dividend at the end of the current year (i.e. one year from today) and a liquidating dividend of $4,840 at the end of 2 years from today. The required return on Gamma’s stock is 10 percent. Ignoring taxes, and transaction costs.

a. What is the value of your shares of stock? Show calculations to support your answer.

b. Suppose shareholders want Gamma to increase its $2,200 dividend payout at the end of the current year to $4,000 and Gamma increases the dividend by issuing at the end of the current year new stock worth the amount needed to increase the dividend. Will the value of your shares change under this scenario? Show calculations to support your answer.

c. Suppose instead of increasing the dividend payout to $4,000 at the end of the current year, the capital raised by new stock is invested by Gamma for a year with an expected return of 21%. What will be the change in the current value of your shares under this scenario? Support your answer with calculations, not just words.

Answer 1

a.

Note- Liquidating dividend menas dividend paid at the time of liquidation of the business. Note-Value of share = PV of future cash receipts Calculation of value of 1000 share of Gamma company Period    cash flow    nature    pvf@10% pv of cash flow 1 2200    Dividend 0.909 2000 2    4840    Liquidation dividend    0.826    4000    Total    6000 Value of our 100 shares =$6000/1000 Shares * 100 shares =$600

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b.

Amount to be raisedto pay extra divideds = $ 4000-$2200 = $1800 suppose share are issued @$10 per share. hence total share to be issues = $1800/$10 = 180 shares now total share of gamma company = 1000+180 = 1180 shares Period    cash flow    nature    pvf@10% pv of cash flow 1 4000    Dividend 0.909 3636 2    4840    Liquidation dividend    0.826    4000    Total    7636 Total value of 1180 share is $ 7636 Value of our 100 share = $7636/1180*100=$647.12

c.

Amount to be raisedto pay extra divideds = $ 4000-$2200 = $1800 suppose share are issued @$10 per share. hence total share to be issues = $1800/$10 = 180 shares now total share of gamma company = 1000+180 = 1180 shares Amount to be received from the investment of $1800 after 2 year= $ 1800(1.21)= $2178 Period    cash flow    nature    pvf@10% pv of cash flow 1 2200    Dividend 0.909 2000 2    4840    Liquidation dividend    0.826    4000 2    2178 investment value 0.826 1800    Total 7800 value of our 100 shares = $7800/1180 shares*100 shares = $661.02