Question

8.      Mr. Toriop owns 5000 shares of stock in Yummy Corporation. The company has announced that it will pay a dividend of $5 per share in one year and then a liquidating dividend of $50 per share in two years. The required return on ABC stock is 10%. (21 marks)

a. What is the current share price of your stock?                           (1 mark)

b. What will be the company’s share price in one year?                   (1 mark)

c. Mr. Toriop wishes to have equal amount of dividend income for the next two years. How can he use homemade leverage on Yummy Corporation’s dividends to achieve this goal? Check that the present value of the cash flows will be the same as they are before the homemade leverage. (Hint: Dividends will be in the form of an annuity.) (8 marks)

d. Suppose Mr. Toriop is thinking about buying a house for $220,000 in one year. How can he use homemade leverage on Yummy Corporation’s dividends to achieve this goal? Check that the present value of the cash flows will be the same as they are before the homemade leverage.                               (5 marks)

e. Suppose Mr. Toriop is thinking about postponing the house purchase for two years, by which time the price of the house will have increased by $35,000. How can he use homemade leverage on Yummy Corporation’s dividends to achieve this goal? Check that the present value of the cash flows will be the same as they are before the homemade leverage.      (6 marks)

Answer 1

No. of shares	Given	5000
Dividend	Given	5
Liquidating dividend	Given	50
Required return	Given	10%
Discount factor	Formula	1/(1+Discount rate)^No. of years
Year	Cash flow	Discount factor	Discounted cash flow
1	5	0.9091	4.55
2	50	0.8264	41.32
Current stock price	45.87
Company's share price in 1 year
Year	Cash flow	Discount factor	Discounted cash flow
0	5	1.0000	5.00
1	50	0.9091	45.45
Price after 1 year	50.45
Price after 2 years is same as value of liquidating dividend i.e. 50.
Dividend after 1 year	5000*5	25000
Price after 1 year		50.45
Price after 2 years		50
Since cash flow of both years to be equal
Let no. of shares to be sold after 1 year to generate homemade dividend be x.
25000+(x*50.45) =	(5000-x)*50
25000+50.45x =	250000-50x
100.45x =	225000
x=	225000/100.45
x=	2239.920358
Therefore, sell 2240 shares after receiving 1st year's dividend to get homemade dividend.
Cash flow after one year
From sale of shares	2240*50.45	113008
From dividend	5000*5	25000
		138008
Cash flow after 2 years
From liquidating dividend	(5000-2240)*50	139242
If cost of house is 220,000
Cash flow from dividend	5000*5	25000
Balance cost to be recovered from sale of shares	220000-25000	195000
Price per share		50.45
No. of shares to be sold	195000/50.45	3,865.21
By selling 3866 shares, the goal can be achieved.
If cost of house increases to	220000+35000=	255000
Cash flow of first year	5000*5	25000
Liquidating dividend of 2nd year	5000*50	250000
		275000
There is no need to utilize homemade dividends.
The cash flow arising at the end of 2 years will be sufficient to cover the cost of house.