Question

Mr. Toriop owns 5000 shares of stock in Yummy Corporation. The company has announced that it will pay a dividend of $5 per share in one year and then a liquidating dividend of $50 per share in two years. The required return on ABC stock is 10%.

a. What is the current share price of your stock?

b. What will be the company’s share price in one year?

c.       Mr. Toriop wishes to have equal amount of dividend income for the next two years. How can he use homemade leverage on Yummy Corporation’s dividends to achieve this goal? Check that the present value of the cash flows will be the same as they are before the homemade leverage. (Hint: Dividends will be in the form of an annuity.)

Answer 1

Solution

a) No. of shares	Given	5000
Dividend	Given	5
Liquidating dividend	Given	50
Required return	Given	10%
Discount factor	Formula	1/(1+Discount rate)^No. of years
Year	Cash flow	Discount factor	Discounted cash flow
1	5	0.9091	4.55
2	50	0.8264	41.32
Current stock price	45.87
b) Company's share price in 1 year
Year	Cash flow	Discount factor	Discounted cash flow
0	5	1.0000	5.00
1	50	0.9091	45.45
Price after 1 year	50.45
Price after 2 years is same as value of liquidating dividend i.e. 50.
c)
Dividend after 1 year	5000*5	25000
Price after 1 year		50.45
Price after 2 years		50
Since cash flow of both years to be equal
Let no. of shares to be sold after 1 year to generate homemade dividend be x.
25000+(x*50.45) =	(5000-x)*50
25000+50.45x =	250000-50x
100.45x =	225000
x=	225000/100.45
x=	2239.920358
Therefore, sell 2240 shares after receiving 1st year's dividend to get homemade dividend.