Question

The Quick Buck Company is an all-equity firm that has been in existence for the past three years. Company management expects that the company will last for two more years and then be dissolved. The firm will generate cash flows of $500,000 next year and $800,000 in two years, including the proceeds from the liquidation. There are 20,000 shares of stock outstanding and shareholders require a return of 12 percent.

Requirement 1:

What is the current price per share of the stock? (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).)

Share price

$

The Board of Directors is dissatisfied with the current dividend policy and proposes that a dividend of $600,000 be paid next year. To raise the cash necessary for the increased dividend, the company will sell new shares of stock.

Requirement 2:

How many shares of stock must be sold? (Do not round intermediate calculations. Round your answer to 2 decimal places (e.g., 32.16).)

Shares sold

Requirement 3:

What is the new price per share of the existing shares of stock? (Do not round intermediate calculations.Round your answer to 2 decimal places (e.g., 32.16).)

New share price

$

Answer 1

a) What is the current share price?

Year 1: dividend per share = 500000 / 20000 = $ 25

Year 2: dividend per share = 800000 / 20000 = $ 40

The required return is 12%, so the share price today is

P₀ = $ 25 * 1/(1+0.12)¹ + $ 40 * 1/(1+0.12)²

= $ 54.21

Req 2

The amount of extra cash the firm must raise to fund this dividend increase Dividend increase

= $600 000 –$500 000 = $100 000

Shortfall = $100 000

The firm needs to raise an additional $100,000 in year 1 to make up the cash shortfall

Market value of equity at t=1 is determined by the CFs paid out at t=2.

800000/1.12 = 714285.71

100000 = n * p

714285.71 = 20000 + n * p

n =3255.81, p = 30.71 (hence we need to sell 3255.81 new shares at $30.71/share)

Req 3

So, the dividend per share to the current shareholders will now be:

Year 1 dividend per share = 600000 / 20000 = $30

Year 2 dividend per share = 800000 / (20000 + 3256) = 34.4

The new share price today = $ 30 /1.12 + $ 34.40 / 1.12² = $ 54.21