Question

You own 1,100 shares of stock in Avondale Corporation. You will receive a dividend of $1.50 per share in one year. In two years, the company will pay a liquidating dividend of $45 per share. The required return on the company's stock is 20 percent.

  

a.	Ignoring taxes, what is the current share price of your stock? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
b.	If you would rather have equal dividends in each of the next two years, how many shares would you sell in one year? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)
c.	What would your cash flow be for each year for the next two years if you create equal homemade dividends? Hint: Dividends will be in the form of an annuity. (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

    

Answer 1

Solution:
a.	Share price	$32.50
Working Notes:
	Using DDM
	P0= D1/(1+r)^1 + D2/(1+r)^2
	P0 = current share price of the stock = ??
	D1= Dividend in year 1 = $1.50
	D2= Dividend in year 2 = $45
	r=required return on the company's stock = 20%
	P0= D1/(1+r)^1 + D2/(1+r)^2
	P0= $1.50/(1+0.20)^1 + 45/(1+0.20)^2
	P0= $32.50
b.	Number of shares	580	shares
Working Notes:
	If we received equal dividend instead of unequal $1.5 & $45
	Let D be the equal dividend received each year so that it current share price still remain $32.50 at required rate of return of 20%
	Using DDM
	P0= D1/(1+r)^1 + D2/(1+r)^2
	P0 = current share price of the stock = $32.50
	D1= Dividend in year 1 = D
	D2= Dividend in year 2 = D
	r=required return on the company's stock = 20%
	P0= D1/(1+r)^1 + D2/(1+r)^2
	32.50= D/(1+0.20)^1 + D/(1+0.20)^2
	32.50= D(1/(1+0.20) + 1/(1+0.20)^2)
	32.50= D(1.52777777777)
	D= 32.50/1.527777777
	D=$21.27272728
	D=$21.27
	So amount to be received in year 1 under equal dividend regime
	= no of shares x Equal dividend per share
	=1,100 x $21.27272728
	=$23,400
	But we will received $1.50 per share
	= no of shares x $1.50
	= 1,100 x $1.50
	=$1,650
	so for balance deficit we will sell share
	Deficit = $23,400 - $1,650 =$21,750
	Share price at end of year 1 P1 = D2/(1+r)
	P1 =45/(1.20)
	P1 =$37.50
	So for $21,750 @ $37.50 per share sold
	Number of share sold =$21,750/$37.50
	Number of share sold =580 shares
c.	Cash flow	23,400
Working Notes:
	Year 2 cash flow will be dividend received $45 per share on the shares still own
	= No of shares still owned x $45
	=(1,100 - 580 ) x 45
	=520 x 45
	=23,400
Notes:	Cash flow for Year 1 was homemade $23,400 and we get Year 2 also $23,400
Please feel free to ask if anything about above solution in comment section of the question.