Question

You own 5,000 shares of stock in a firm. You will receive $4 per share dividend in one year. in two years the firm will pay a liquidating dividend of $60 per share. The required return on the company's stock is 16 percent. Ignore taxes, transaction costs, and other imperfections.

a. Find the current share price of the stock.

b. If you would rather have equal dividend on each of the next two years. Show how much you can achieve this by creating homemade dividends.
What is the amount of cash flow you would receive from your strategy in the second year?

c. Suppose you want only $8,000 total in dividends the first year. What will your homemade dividend be in two years?

Answer 1

a) Price per share = D1 / (1 + r) + D2 / (1 + r)^2 = 4 / 1.16 + 60 / 1.16^2 = $48.04

b) Price in year 1 = D2 / (1 + r) = 60 / 1.16 = $51.72

Assume you sell y shares in year 1 to create homemade dividends.

=> 5000 x 4 + 51.72 x y = 60 x (5000 - y)

=> (60 + 51.72) x y = 5000 x (60 - 4)

=> y = 2,506 shares

You should sell 2,506 shares in year 1 after receiving the dividends and would receive dividends on 2,494 shares in year 2.

c) You have 5000 shares and will receive 5000 x 4 = 20,000 in year 1. In case you want only 8,000, you need to buy shares worth 12,000 in year 1.

No. of shares you buy in year 1 = 12,000 / 51.72 = 232 shares

Dividends in year 2 = 60 x (5000 + 232) = $313,920