Question

Mr. Toriop owns 5,000 shares of stock in Yummy Corporation. The company has announced that it will pay a dividend of $5 per share in one year and a liquidating dividend of $50 per share in two years. The required return on Yummy stock is 12%.   

a. What is the current share price of your stock?                                 (1 mark)

b. What will be the company’s share price in one year’s time?                (1 mark)

c. Mr. Toriop wishes to have equal amounts of dividend income for the next two years. How can he use homemade dividends to achieve this goal? Check that the present value of the cash flows will be the same as it is before the homemade dividends. (Hint: Dividends will be in the form of an annuity.)                         

d. Suppose Mr. Toriop is thinking about buying a house for $220,000 in one year. How can he use homemade dividends to achieve this goal? Check that the present value of the cash flows will be the same as it is before the homemade dividends.                                                                                 

e.       Suppose Mr. Toriop is thinking about postponing the house purchase for two years, by which time the price of the house will have increased by $46,800. How can he use homemade dividends to achieve this goal? Check that the present value of the cash flows will be the same as it is before the homemade dividends.

Answer 1

a.	Current share price =		PV of dividends
			5/1.12 + 50/(1.12^2)
			44.32398
b.	Price after 1 year =		50/1.12
			44.64286
c.	PV of dividends should be equal for both the cases(i.e. homemade or actual)
	so,	let the dividend be D,
	44.324 x 5000	= D x PVAF(12%,2)
	221620	= D x 1.69
	D=	221620/1.69
	D=	131132.1
	To make these homemade dividend, he should -
	Year 1-
	Dividend received =		5000 x 5=	25000
	Balance required dividend =		131132.1 -25000 =	106132.1
	This should be achieved by selling shares @ 44.64
	No. of shares to be sold =		106132.1/44.64286 =	2377.36
	Year 2 =
	Divided received =		(5000-2377.36) x 50	131132
d.	Dividend in 1 year=		5000 x 5=	25000
	Balance required dividend =		220000 -25000 =	195000
	This should be achieved by selling shares @ 44.64
	No. of shares to be sold =		195000/44.64289	4368
e.	Amount available at the end of year2 =		5000 x 50 =	250000
	Balance amount required for house		220000+46800-250000 =	16800
	This should be received by investing such amount for 1 year from dividend of year1 that will become 16800 at t = 2
	Amount to be invested today =		16800/(1.12) =	15000
	This can be achieved by -
	Dividend for year 1 =		5000 x 5=	25000
	Out of this invest 15000 for 1 year @ 12%
	Amount at year end 2 =
	Investment =			16800
	Dividend for year 2 =		5000 x 50 =	250000