Question

You own 100 shares of stock of unlevered Gamma Company which has 1000 shares outstanding. Gamma plans to pay $2,200 dividend at the end of the current year (i.e. one year from today) and a liquidating dividend of $4,840 at the end of 2 years from today. The required return on Gamma’s stock is 10 percent. Ignoring taxes, and transaction costs.

a. What is the value of your shares of stock? Show calculations to support your answer.

b. Suppose shareholders want Gamma to increase its $2,200 dividend payout at the end of the current year to $4,000 and Gamma increases the dividend by issuing at the end of the current year new stock worth the amount needed to increase the dividend. Will the value of your shares change under this scenario? Show calculations to support your answer.

c. Suppose instead of increasing the dividend payout to $4,000 at the end of the current year, the capital raised by new stock is invested by Gamma for a year with an expected return of 21%. What will be the change in the current value of your shares under this scenario? Support your answer with calculations, not just words.

Answer 1

Solution:

a)Calculation of value of shares

Value of share=Dividend for 1st year/(1+required rate)+Dividend for 2nd year/(1+required rate)^2

=$2200/(1+0.10)+$4,840/(1+0.10)^2

=$6000 per share

Value of shares=100*$6000=$600,000

b)In the given case the value per share will not change as the amount of dividend for both year does not change.

Value of shares=$2200/(1+0.10)+$4,840/(1+0.10)^2

=$6,000

c)Under this scenario,value of my shares will be decreases as amount of dividends are same but the required rate of return has increases.

Value of shares=Dividend for 1st year/(1+required rate)+Dividend for 2nd year/(1+required rate)^2

=$2200/(1+0.21)+$4,840/(1+0.21)^2

=$5,123.97