Question

Smith holds 100,000 shares of stock in Avondale Corporation. Each year, he

received $1 dividend per share from Avondale. Recently, Smith considers moving from

Florida to California and expects that he will need to double his living expense. Therefore,

Smith plans to sell stocks of Avondale Corporation and purchase stocks of Bravo

Corporation, which pays $2 dividend per share. In fact, Avondale and Bravo are identical

except the dividend policy. John suggests that Smith does not need to change his stock

investment and can create a cash flow stream equivalent to $2 dividend per share by holding

Avondale’s stock. What is the strategy in John’s mind

Answer 1

The cashflow stream of $2 per share can be achieved by the concept of Homemade dividends which can be created by Selling a part of the shares so that the requird cashflows can be achieved. This is the strategy in John's mind.

Here, Smith's target is total $200,000 in dividends

So, after the 100,000 stocks of Avondale pays a dividend of $1 each, he can sell one part of stocks so that he realises the remaining $100,000 from stock sale

Suppose the price of the Avondale stock ex-dividend is $100, then he can sell 1000 stocks to achieve his target cashflow ($100000 from dividends and $100000 from stock sale)

MM theory says that this will not make a difference as the other stock Bravo will decrease in price after paying more dividends.