Question

You own 1,800 shares of stock in Avondale Corporation. You will receive a $1.50 per share dividend in one year. In two years, the company will pay a liquidating dividend of $80 per share. The required return on the company's stock is 25 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? Hint: Dividends will be in the form of an annuity. (Do not round intermediate calculations.)

a. Share price: ________

b. Number of shares: ________

c. Cash flow: _________

Answer 1

(a) Dividends One Year from Now = $ 1.5 per share, Dividends Two Years from now = $ 80 per share, Number of Shares held Now (at time t=0) = 1800

Required Rate of Return = 25 %

Current Stock Price should equal the total present value of the dividend cash flows discounted at the required rate of return so as to conform with the principles of time value of money.

Therefore, Current Stock Price = 1.5 / 1.25 + [80/(1.25)^(2)] = $ 52.4

If the investor wants to earn equal dividends in both years, then Dividend at the end of Year 1 = Dividend at the end of Year 2

Therefore, 1800 x 1.5 = N x 80 (where N is the number of shares held at the end of Year 2)

N = (1800 x 1.5) / 80 = 33.75

Number of Shares Sold at the end of Year 2 = 1800 - 33.75 = 1766.25

Cash Flow Received at the end of Year 1 = 1800 x 1.5 = $ 2700

Cash Flow Received at the end of Year 2 = 1800 x 80 = $ 144000