Question

You own 1,000 shares of stock in Avondale Corporation. You will receive a dividend of $2.90 per share in one year. In two years, the company will pay a liquidating dividend of $59 per share. The required return on the company's stock is 14 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 2 decimal places, e.g., 32.16.)

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 2 decimal places, e.g., 32.16.)

Answer 1

a) Computaton of Current shareprice of a stock.

We know that Current share price represent present value of future cash payments

Current share price = PV of Dividend in Year 1+ PV of liquidating dividend in year 2

Current share price = D1/ ( 1+i) + D2 / ( 1+i)^2

=$ 2.90/ ( 1.14)^1+ $ 59/ ( 1.14)^2

= $ 2.90/1.14 + $ 59/1.2996

= $ 2.54386+$ 45.39858

= $ 47.94

Hence Current share price of a stock is $ 47.94

c)Computation of Cash flow in each year.

Given there is a equal homemade dividend for net twoyears

Let the dividend amount be D in each year

We know that Current share price represent present value of future cash payments

Current share price = PV of Dividend in Year 1+ PV of liquidating dividend in year 2

Current share price = D1/ ( 1+i) + D2 / ( 1+i)^2

$ 47.94=D/ 1.14+ D / ( 1.14)^2

$47.94= D /1.14+ D /1.2996

$ 47.94 =( 1.14D+D) / 1.2996

$ 47.94 = 2.14D /1.2996

($ 47.94* 1.2996) /2.14= D

D = 29.11

Hence the Cash flow in each year is $ 29.11

b) As per home made dividend we have to receive $ 29.11 per year

Target Cash flow in year 1 = No.of shares owned* Homemade dividend

= 1000*$ 29.11

= $ 29110

But the Cash flow in year 1 = Actual dividend * No.of shares owned

= $ 2.90*1000

=$ 2900

Hence Additional Cash flow needed = Target Cash flow- Actual cash flow

= $ 29110-$ 2900

= $ 26210

No.of shares to be sold = Additional Cash flow required/ Share price at the end of Y1

= $26210/$ 51.75

= $ 506.47

Computation of shareprice at the end of year 1

We know that Current share price represent present value of future cash payments

Current share price = PV of liquidating dividend

=Liquidating dividend / ( 1+i)

= $ 59/1.14

= $ 51.75

Hence the share price after year 1 is $ 51.75.

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