6 Dividend Icai PDF

4
Dividend Decisions
BASIC CONCEPTS AND FORMULAE
1. Introduction
Dividend refers to that portion of profit (after tax) which is distributed among the
owners/shareholders of the firm and the profit which is not distributed is known as
retained earnings. The dividend policy of the company should aim at achieving the
objective of the company to maximise shareholder’s wealth.
2. Practical Considerations in Dividend Policy
The practical considerations in dividend policy of a company are as below:
(a) Financial Needs of the Company;
(b) Constraints on Paying Dividends- Such as legal, liquidity, access to capital
market and investment opportunities;
(c) Desire of Shareholders; and
(d) Stability of Dividends.
3. Forms of Dividend
Dividends can be divided into the following forms:
(i) Cash Dividend; and
(ii) Stock Dividend.
4. Theories on Dividend Policies
(a) Traditional Position: Expounded by Graham and Dodd, the stock market places
considerably more weight on dividends than on retained earnings. Expressed
quantitatively in the following valuation model:
P = m (D + E/3)
If E is replaced by (D+R) then,
P = m ( 4D/3 ) + m ( R/3 )
(b) Walter Approach: Given by Prof. James E. Walter, the approach focuses on
how dividends can be used to maximise the wealth position of equity holders.
© The Institute of Chartered Accountants of India

Dividend Decisions 4.2
The relationship between dividend and share price on the basis of Walter’s
formula is shown below:
Ra
D+ (E − D)
Rc
Vc =
Rc
Where,
Vc = Market value of the ordinary shares of the company
Ra = Return on internal retention, i.e., the rate company earns on
retained profits
Rc = Cost of Capital
E= Earnings per share
D= Dividend per share.
(c) Gordon Growth Model: This theory also contends that dividends are relevant.
This model explicitly relates the market value of the firm to dividend policy. The
relationship between dividend and share price on the basis of Gordon's formula
is shown as:
⎡ d (1 + g) ⎤
VE = ⎢ o ⎥
⎣ ke - g ⎦
Where,
VE = Market price per share (ex-dividend)
do = Current year dividend
g = Constant annual growth rate of dividends
Ke = Cost of equity capital (expected rate of return)
(d) Modigliani and Miller (MM) Hypothesis: This hypothesis states that under
conditions of perfect capital markets, rational investors, absence of tax
discrimination between dividend income and capital appreciation, given the firm's
investment policy, its dividend policy may have no influence on the market price
of shares. MM Hypothesis is primarily based on the arbitrage argument. Market
price of a share after dividend declared on the basis of MM model is shown
below:
P1 + D1
Po =
1+ Ke

4.3 Strategic Financial Management
Where,
Po = The prevailing market price of a share
Ke = The cost of equity capital
D1 = Dividend to be received at the end of period one
P1 = Market price of a share at the end of period one.
If the firm were to finance all investment proposals, the total amount raised
through new shares will be ascertained with the help of the following formula:
I - (E - nD1 )
ΔN =
P1
Question 1
Write short note on effect of a Government imposed freeze on dividends on stock prices and
the volume of capital investment in the background of Miller-Modigliani (MM) theory on
dividend policy.
Answer
Effect of a Government Imposed Freeze on Dividends on Stock Prices and the Volume of
Capital Investment in the Background of (Miller-Modigliani) (MM) Theory on Dividend Policy
According to MM theory, under a perfect market situation, the dividend of a firm is irrelevant as
it does not affect the value of firm. Thus under MM’s theory the government imposed freeze on
dividend should make no difference on stock prices. Firms if do not pay dividends will have
higher retained earnings and will either reduce the volume of new stock issues, repurchase
more stock from market or simply invest extra cash in marketable securities. In all the above
cases, the loss by investors of cash dividends will be made up in the form of capital gains.
Whether the Government imposed freeze on dividends have effect on volume of capital
investment in the background of MM theory on dividend policy have two arguments. One
argument is that if the firms keep their investment decision separate from their dividend and
financing decision then the freeze on dividend by the Government will have no effect on
volume of capital investment. If the freeze restricts dividends the firm can repurchase shares
or invest excess cash in marketable securities e.g. in shares of other companies. Other
argument is that the firms do not separate their investment decision from dividend and
financing decisions. They prefer to make investment from internal funds. In this case, the
freeze of dividend by government could lead to increased real investment.
Question 2
Write short note on factors determining the dividend policy of a company.

Answer
Factors Determining the Dividend Policy of a Company
(i) Liquidity: In order to pay dividends, a company will require access to cash. Even very
profitable companies might sometimes have difficulty in paying dividends if resources are
tied up in other forms of assets.
(ii) Repayment of debt: Dividend payout may be made difficult if debt is scheduled for
repayment.
(iii) Stability of Profits: Other things being equal, a company with stable profits is more likely
to pay out a higher percentage of earnings than a company with fluctuating profits.
(iv) Control: The use of retained earnings to finance new projects preserves the company’s
ownership and control. This can be advantageous in firms where the present disposition
of shareholding is of importance.
(v) Legal consideration: The legal provisions lay down boundaries within which a company
can declare dividends.
(vi) Likely effect of the declaration and quantum of dividend on market prices.
(vii) Tax considerations and
(viii) Others such as dividend policies adopted by units similarly placed in the industry,
management attitude on dilution of existing control over the shares, fear of being
branded as incompetent or inefficient, conservative policy Vs non-aggressive one.
(ix) Inflation: Inflation must be taken into account when a firm establishes its dividend policy.
Question 3
What are the determinants of Dividend Policy?
Answer
Determinants of dividend policy
Many factors determine the dividend policy of a company. Some of the factors determining the
dividend policy are:
(i) Dividend Payout ratio: A certain share of earnings to be distributed as dividend has to
be worked out. This involves the decision to pay out or to retain. The payment of
dividends results in the reduction of cash and, therefore, depletion of assets. In order to
maintain the desired level of assets as well as to finance the investment opportunities,
the company has to decide upon the payout ratio. D/P ratio should be determined with
two bold objectives – maximising the wealth of the firms’ owners and providing sufficient
funds to finance growth.
(ii) Stability of Dividends: Generally investors favour a stable dividend policy. The policy
should be consistent and there should be a certain minimum dividend that should be paid

regularly. The liability can take any form, namely, constant dividend per share; stable D/P
ratio and constant dividend per share plus something extra. Because this entails – the
investor’s desire for current income, it contains the information content about the
profitability or efficient working of the company; creating interest for institutional
investor’s etc.
(iii) Legal, Contractual and Internal Constraints and Restriction: Legal and Contractual
requirements have to be followed. All requirements of Companies Act, SEBI guidelines,
capital impairment guidelines, net profit and insolvency etc., have to be kept in mind
while declaring dividend. For example, insolvent firm is prohibited from paying dividends;
before paying dividend accumulated losses have to be set off, however, the dividends
can be paid out of current or previous years’ profit. Also there may be some contractual
requirements which are to be honoured. Maintenance of certain debt equity ratio may be
such requirements. In addition, there may be certain internal constraints which are
unique to the firm concerned. There may be growth prospects, financial requirements,
availability of funds, earning stability and control etc.
(iv) Owner’s Considerations: This may include the tax status of shareholders, their
opportunities for investment dilution of ownership etc.
(v) Capital Market Conditions and Inflation: Capital market conditions and rate of inflation
also play a dominant role in determining the dividend policy. The extent to which a firm
has access to capital market, also affects the dividend policy. A firm having easy access
to capital market will follow a liberal dividend policy as compared to the firm having
limited access. Sometime dividends are paid to keep the firms ‘eligible’ for certain things
in the capital market. In inflation, rising prices eat into the value of money of investors
which they are receiving as dividends. Good companies will try to compensate for rate of
inflation by paying higher dividends. Replacement decision of the companies also affects
the dividend policy.
Question 4
How tax considerations are relevant in the context of a dividend decision of a company?
Answer
Dividend Decision and Tax Considerations
Traditional theories might have said that distribution of dividend being from after-tax profits,
tax considerations do not matter in the hands of the payer-company. However, with the arrival
of Corporate Dividend Tax on the scene in India, the position has changed. Since there is a
clear levy of such tax with related surcharges, companies have a consequential cash outflow
due to their dividend decisions which has to be dealt with as and when the decision is taken.
In the hands of the investors too, the position has changed with total exemption from tax being
made available to the receiving-investors. In fact, it can be said that such exemption from tax

has made the equity investment and the investment in Mutual Fund Schemes very attractive in
the market.
Broadly speaking Tax consideration has the following impacts on the dividend decision of a
company:
Before Introduction of Dividend Tax: Earlier, the dividend was taxable in the hands of
investor. In this case the shareholders of the company are corporates or individuals who are in
higher tax slab; it is preferable to distribute lower dividend or no dividend. Because dividend
will be taxable in the hands of the shareholder @ 30% plus surcharges while long term capital
gain is taxable @ 10%. On the other hand, if most of the shareholders are the people who are
in no tax zone, then it is preferable to distribute more dividends.
We can conclude that before distributing dividend, company should look at the shareholding
pattern.
After Introduction of Dividend Tax: Dividend tax is payable @ 12.5% - surcharge +
education cess, which is effectively near to 14%. Now if the company were to distribute
dividend, shareholder will indirectly bear a tax burden of 14% on their income. On the other
hand, if the company were to provide return to shareholder in the form of appreciation in
market price – by way of Bonus shares – then shareholder will have a reduced tax burden. For
securities on which STT is payable, short term capital gain is taxable @ 10% while long term
capital gain is totally exempt from tax.
Therefore, we can conclude that if the company pays more and more dividend (while it still
have reinvestment opportunities) then to get same after tax return shareholders will expect
more before tax return and this will result in lower market price per share.
Question 5
According to the position taken by Miller and Modigliani, dividend decision does not influence value.
Please state briefly any two reasons, why companies should declare dividend and not ignore it.
Answer
The position taken by M & M regarding dividend does not take into account certain practical
realities is the market place. Companies are compelled to declare annual cash dividends for
reasons cited below:-
(i) Shareholders expect annual reward for their investment as they require cash for meeting
needs of personal consumption.
(ii) Tax considerations sometimes may be relevant. For example, dividend might be tax free
receipt, whereas some part of capital gains may be taxable.
(iii) Other forms of investment such as bank deposits, bonds etc, fetch cash returns
periodically, investors will shun companies which do not pay appropriate dividend.
(iv) In certain situations, there could be penalties for non-declaration of dividend, e.g. tax on
undistributed profits of certain companies.

Question 6
Write a short note on Traditional & Walter Approach to Dividend Policy
Answer
According to the traditional position expounded by Graham and Dodd, the stock market
places considerably more weight on dividends than on retained earnings. For them, the
stock market is overwhelmingly in favour of liberal dividends as against niggardly
dividends. Their view is expressed quantitatively in the following valuation model:
P = m (D + E/3)
Where,
P = Market Price per share
D = Dividend per share
E = Earnings per share
m = a Multiplier.
As per this model, in the valuation of shares the weight attached to dividends is equal
to four times the weight attached to retained earnings. In the model prescribed, E is
replaced by (D+R) so that
P = m {D + (D+R)/3}
= m (4D/3) + m (R/3)
The weights provided by Graham and Dodd are based on their subjective judgments
and not derived from objective empirical analysis. Notwithstanding the subjectivity of
these weights, the major contention of the traditional position is that a liberal payout
policy has a favourable impact on stock prices.
The formula given by Prof. James E. Walter shows how dividend can be used to
maximise the wealth position of equity holders. He argues that in the long run, share
prices reflect only the present value of expected dividends. Retentions influence stock
prices only through their effect on further dividends. It can envisage different possible
market prices in different situations and considers internal rate of return, market
capitalisation rate and dividend payout ratio in the determination of market value of
shares.
Walter Model focuses on two factors which influences Market Price
(i) Dividend Per Share.
(ii) Relationship between Internal Rate of Return (IRR) on retained earnings and
market expectations (cost of capital).
If IRR > Cost of Capital, Share price can be even higher in spite of low dividend. The
relationship between dividend and share price on the basis of Walter’s formula is

shown below:
Ra
D+ (E-D)
Rc
Vc =
Rc
Where,
Vc = Market value of the ordinary shares of the company
Ra = Return on internal retention, i.e., the rate company earns on retained
profits
D = Dividend per share.
Question 7
Sahu & Co. earns ` 6 per share having capitalisation rate of 10 per cent and has a return on
investment at the rate of 20 per cent. According to Walter’s model, what should be the price
per share at 30 per cent dividend payout ratio? Is this the optimum payout ratio as per Walter?
Answer
Ra
D+ (E - D)
Rc
Walter Model is Vc =
Rc
Where:
Vc = Market value of the share
Ra = Return on Retained earnings
Rc = Capitalisation Rate
E = Earning per share
Hence, if Walter model is applied
.20
1.80 + (6 - 1.80) 1.80 + .20 ( 4.20)
Market Value of the Share P= .10 P= .10
0.10 0.10
1.80 + 8.40
P= P = ` 102
0.10

This is not the optimum payout ratio because Ra > Rc and therefore Vc can further go up if
payout ratio is reduced.
Question 8
The following figures are collected from the annual report of XYZ Ltd.:
`
Net Profit 30 lakhs
Outstanding 12% preference shares 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
What should be the approximate dividend pay-out ratio so as to keep the share price at ` 42
by using Walter model?
Answer
` in lakhs
Net Profit 30
Less: Preference dividend 12
Earning for equity shareholders 18
Therefore earning per share ` 18 lakhs / 3 lakhs = ` 6.00
Cost of capital i.e. (ke)
(Assumed) 16%*
Let, the dividend payout ratio be X and so the share price will be:
r(E - D)
D Ke
P = +
Ke Ke
Here D = 6x; E = ` 6; r = 0.20 and Ke = 0.16 and P = ` 42
6x 0.2 (6 - 6x)
Hence ` 42 = +
0.16 0.16 × 0.16
Or, ` 42 = 37.50x + 46.875 (1 –x)
= 9.375x = 4.875
x = 0.52
So, the required dividend payout ratio will be = 52%
*Students can assume any percentage other than 16%.

Question 9
The following information pertains to M/s XY Ltd.
Earnings of the Company `5,00,000
Dividend Payout ratio 60%
No. of shares outstanding 1,00,000
Equity capitalization rate 12%
Rate of return on investment 15%
(i) What would be the market value per share as per Walter’s model?
(ii) What is the optimum dividend payout ratio according to Walter’s model and the market
value of Company’s share at that payout ratio?
Answer
(a) M/s XY Ltd.
(i) Walter’s model is given by
D + (E − D)(r / k e )
P=
Ke
Where,
P = Market price per share.
E = Earnings per share = `5
D = Dividend per share = `3
r = Return earned on investment = 15%
Ke = Cost of equity capital = 12%
0.15 0.15
3 + (5 - 3) × 3 + 2×
P = 0.12 = 0.12
0.12 0.12
= `45.83
(ii) According to Walter’s model when the return on investment is more than the cost of
equity capital, the price per share increases as the dividend pay-out ratio
decreases. Hence, the optimum dividend pay-out ratio in this case is nil.
So, at a pay-out ratio of zero, the market value of the company’s share will be:
0.15
0 + ( 5 − 0)
0.12 = Rs.52.08
0.12

Question 10
The following information is supplied to you:
`
Total Earnings 2,00,000
No. of equity shares (of `100 each) 20,000
Dividend paid 1,50,000
Price/Earning ratio 12.5
(i) Ascertain whether the company is the following an optimal dividend policy.
(ii) Find out what should be the P/E ratio at which the dividend policy will have no effect on
the value of the share.
(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5?
Answer
(i) The EPS of the firm is ` 10 (i.e., ` 2,00,000/20,000). The P/E Ratio is given at 12.5 and
the cost of capital, ke, may be taken at the inverse of P/E ratio. Therefore, ke is 8 (i.e.,
1/12.5). The firm is distributing total dividends of `1,50,000 among 20,000 shares, giving
a dividend per share of `7.50. the value of the share as per Walter’s model may be found
as follows:
D (r / K e ) (E − D)
P= +
Ke Ke
7.50 (.10 / .08) (10 − 7.5)
= +
.08 .08
= `132.81
The firm has a dividend payout of 75% (i.e., `1,50,000) out of total earnings of
`2,00,000. since, the rate of return of the firm, r, is 10% and it is more than the ke of 8%,
therefore, by distributing 75% of earnings, the firm is not following an optimal dividend
policy. The optimal dividend policy for the firm would be to pay zero dividend and in such
a situation, the market price would be
D (r / K e ) (E − D)
P= +
ke Ke
0 (.10 / .80) (10 − 0)
= +
.08 .08
= `156.25
So, theoretically the market price of the share can be increased by adopting a zero
payout.

(ii) The P/E ratio at which the dividend policy will have no effect on the value of the share is
such at which the ke would be equal to the rate of return, r, of the firm. The Ke would be
10% (=r) at the P/E ratio of 10. Therefore, at the P/E ratio of 10, the dividend policy
would have no effect on the value of the share.
(iii) If the P/E is 8 instead of 12.5, then the ke which is the inverse of P/E ratio, would be 12.5
and in such a situation ke > r and the market price, as per Walter’s model would be
D (r / K e ) (E − D)
P= +
Ke Ke
7.50 (.1 / .125) (10 − 7.5)
+
= .125 .125
= `76
The optimal dividend policy for the firm would be to pay 100% dividend and market price
of share in such case would be
10.0 (0.1/ 0.125) (10 -10)
P= 0.125 + 0.125
= ` 80
Question 11
The following information relates to Maya Ltd:
Earnings of the company ` 10,00,000
Dividend payout ratio 60%
No. of Shares outstanding 2,00,000
Rate of return on investment 15%
Equity capitalization rate 12%
(i) What would be the market value per share as per Walter’s model ?
(ii) What is the optimum dividend payout ratio according to Walter’s model and the market
value of company’s share at that payout ratio?
Answer
MAYA Ltd.
(i) Walter’s model is given by –
D + (E − D)( γ / k e )
p=
ke

Where, p = Market price per share,

E = Earning per share – ` 5
D = Dividend per share – ` 3
γ = Return earned on investment – 15%
ke = Cost of equity capital – 12%
0.15 .15
3 + ( 5 − 3) × 3 + 2×
∴p= 0.12 = .12 = ` 45.83
0.12 .12
(ii) According to Walter’s model when the return on investment is more than the cost of
equity capital, the price per share increases as the dividend pay-out ratio decreases.
Hence, the optimum dividend pay-out ratio in this case is Nil. So, at a payout ratio of
zero, the market value of the company’s share will be:-
.15
0 + ( 5 − 0) ×
.12 = ` 52.08
0.12
Question 12
Subhash & Co. earns ` 8 per share having capitalisation rate of 10 per cent and has a return
on investment at the rate of 20 per cent. According to Walter's model, what should be the price
per share at 25 per cent dividend payout ratio? Is this the optimum payout ratio as per
Walter’s Model?
Answer
Walter Model is as follows:-
R
D+ a
(E -D )
R
Ve = c
R c
Vc = Market value of the share

Ra = Return on retained earnings
Re = Capitalisation rate
Hence, if Walter model is applied-
0.20
` 2.00 + (` 8.00 −` 2.00)
Market value of the share VC = 0.10
0.10
or

0.20
` 2.00 + (` 6.00)
VC = 0.10
0.10
or
` 2.00 + ` 2.00 `14.00
VC = = =`140
0.10 0.10
This is not the optimum payout ratio because Ra> Rc and therefore Ve can further group if
payout ratio is reduced.
Question 13
The earnings per share of a company is ` 10 and the rate of capitalisation applicable to it is
10 per cent. The company has three options of paying dividend i.e.(i) 50%,(ii)75% and
(iii)100%. Calculate the market price of the share as per Walter’s model if it can earn a return
of (a) 15, (b) 10 and (c) 5 per cent on its retained earnings.
Answer
r
D+ (E − D)
P= ke
ke
Where
P= Price of Share
R= Rate of Earning
Ke = Rate of Capitalisation or Cost of Equity
(i) (ii) (iii)
DP ratio 50% DP ratio 75% DP ratio 100%
(a) Price of Share if ⎛ .15 ⎞ ⎛ .15 ⎞ ⎛ .15 ⎞

r =15% 5+⎜ ⎟ (10 − 5) 7.5 + ⎜ ⎟ (10 − 7.5) 10 + ⎜ ⎟ (10 − 10)
⎝ .10 ⎠ ⎝ .10 ⎠ ⎝ .10 ⎠
.10 .10 .10
12.5 11.25 10
.10 .10 .10
` 125 ` 112.5 ` 100

(b) Price of Share if ⎛ .10 ⎞ ⎛ .10 ⎞ ⎛ .10 ⎞

r = 10% 5+⎜ ⎟ (10 − 5) 7.5 + ⎜ ⎟ (10 − 7.5) 10 + ⎜ ⎟ (10 − 10)
⎝ .10 ⎠ ⎝ .10 ⎠ ⎝ .10 ⎠
.10 .10 .10
10 10 10
= ` 100 = 100 = ` 100
.10 .1 .1
(c) Price of Share if ⎛ .05 ⎞ ⎛ .05 ⎞ ⎛ .05 ⎞

r = 5% 5+⎜ ⎟ (10 − 5) 7.5 + ⎜ ⎟ (10 − 7.5) 10 + ⎜ ⎟ (10 − 10)
⎝ .10 ⎠ ⎝ .10 ⎠ ⎝ .10 ⎠
.10 .10 .10
7.5 8.75 10
= ` 75 = 87.5 = ` 100
.10 .10 .1
Question 14
X Ltd has an internal rate of return @ 20%. It has declared dividend @ 18% on its equity
shares, having face value of ` 10 each. The payout ratio is 36% and Price Earning Ratio is
7.25. Find the cost of equity according to Walter's Model and hence determine the limiting
value of its shares in case the payout ratio is varied as per the said model.
Answer
Internal Rate of Return (r) = 0.20
Dividend (D) = 1.80
1.80
Earnings Per share (E) = =5
0.36
Price of share (P) = 5 x 7.25 = 36.25
r
D+ (E − D)
ke
P=
Ke
0.20(5 − 1.80)
1.80 +
ke
36.25 =
ke
0.20(3.20)
36.25 Ke = 1.80 +
Ke

0.64
36.25 Ke = 1.80 +
Ke
36.25 Ke2 = 1.80 Ke + 0.64
−b ± b2 − 4ac
Ke=
2a
-1.80 ± (1.80)2 - 4 × (-36.25) × 0.64

=
2 × (-36.25)
−1.80 ± 3.24 + 92.80

=
−72.50
Ke = 16%
Since the firm is a growing firm, then 100% payout ratio will give limiting value of
share
0.20(5 − 5)
1.80 +
P= 0.16
0.16
1.80
=
0.16
= ` 11.25
Thus limiting value is ` 11.25
Question 15
Mr. A is contemplating purchase of 1,000 equity shares of a Company. His expectation of
return is 10% before tax by way of dividend with an annual growth of 5%. The Company’s last
dividend was ` 2 per share. Even as he is contemplating, Mr. A suddenly finds, due to a
Budget announcement Dividends have been exempted from Tax in the hands of the recipients.
But the imposition of Dividend Distribution Tax on the Company is likely to lead to a fall in
dividend of 20 paise per share. A’s marginal tax rate is 30%.
Required:
Calculate what should be Mr. A’s estimates of the price per share before and after the
Budget announcement?

Answer
The formula for determining value of a share based on expected dividend is:
D 0 (1 + g)
P0 =
(k - g)
Where
P0 = Price (or value) per share
D0 = Dividend per share
g = Growth rate expected in dividend
k = Expected rate of return
Hence,
Price estimate before budget announcement:
2 × (1 + 0.05)
P = = ` 42.00
0 (0.10 - 0.05)
Price estimate after budget announcement:

1.80 × (1.05)
P = = ` 94.50
0 (0.07 - 0.05)
Question 16
A firm had been paid dividend at `2 per share last year. The estimated growth of the dividends
from the company is estimated to be 5% p.a. Determine the estimated market price of the
equity share if the estimated growth rate of dividends (i) rises to 8%, and (ii) falls to 3%. Also
find out the present market price of the share, given that the required rate of return of the
equity investors is 15.5%.
Answer
In this case the company has paid dividend of `2 per share during the last year. The growth
rate (g) is 5%. Then, the current year dividend (D1) with the expected growth rate of 5% will be
` 2.10
D1
The share price is = Po =
Ke - g
` 2.10
=
0.155 − 0.05
= ` 20
In case the growth rate rises to 8% then the dividend for the current year. (D1) would be ` 2.16

and market price would be-

` 2.16
=
0.155 − 0.08
= ` 28.80
In case growth rate falls to 3% then the dividend for the current year (D1) would be ` 2.06 and
market price would be-
` 2.06
=
0.155 − 0.03
= `16.48
So, the market price of the share is expected to vary in response to change in expected
growth rate is dividends.
Question 17
The following information is given for QB Ltd.
Earning per share ` 12
Dividend per share ` 3
Cost of capital 18%
Internal Rate of Return on investment 22%
Retention Ratio 40%
Calculate the market price per share using
(i) Gordon’s formula
(ii) Walter’s formula
Answer
(i) Gordon’s Formula
E(1 − b)
P0 =
K − br
P0 = Present value of Market price per share
K = Cost of Capital
b = Retention Ratio (%)
r = IRR
br = Growth Rate
` 12(1 - 0.40)
P0 =
0.18 - (0.40 × 0.22)

` 7.20 ` 7.20
= =
0.18 - 0.088 0.092
= ` 78.26
(ii) Walter’s Formula
R
D + a (E - D)
Rc
Vc =
Rc
Vc = Market Price
Ra = IRR
E= Earnings per share
0.22
`3+ (`12 -` 3)
= 0.18
0.18
` 3 + ` 11
=
0.18
= ` 77.77
Alternative Solution- As per the data provided in the question the retention ratio comes out
to be 75% (as computed below) though mentioned in the question as 40%
(i) Gordon’s Formula
EPS - Dividend Per Share ` 12 - ` 3
Retention Ratio = = = 0.75 i.e. 75%
EPS ` 12
With the retention ratio of 75% market price per share using the Gordons Formula shall
be as follows
E(1 − b)
P0 =
K − br
P0 = Present value of Market price per share
K = Cost of Capital
b = Retention Ratio (%)
r = IRR
br = Growth Rate

12(1- 0.75)
P0 =
0.18 - (0.75 × 0.22)
3
= = ` 200
0.18 - 0.165
(ii) Walter’s Formula
R
D + a (E - D)
Rc
Vc =
Rc
Vc = Market Price
Ra = IRR
0.22
`3+ (` 12 -` 3)
= 0.18
0.18
` 3 +`11
= = ` 77.77
0.18
Question 18
X Ltd., has 8 lakhs equity shares outstanding at the beginning of the year. The current market
price per share is ` 120. The Board of Directors of the company is contemplating ` 6.4 per
share as dividend. The rate of capitalisation, appropriate to the risk-class to which the
company belongs, is 9.6%:
(i) Based on M-M Approach, calculate the market price of the share of the company, when
the dividend is – (a) declared; and (b) not declared.
(ii) How many new shares are to be issued by the company, if the company desires to fund
an investment budget of ` 3.20 crores by the end of the year assuming net income for
the year will be ` 1.60 crores?
Answer
Modigliani and Miller (M-M) – Dividend Irrelevancy Model:
P1 + D1
P0 =
1+ K e
Where,
Po = Existing market price per share i.e. ` 120

P1 = Market price of share at the year-end (to be determined)

D1 = Contemplated dividend per share i.e. ` 6.4
Ke = Capitalisation rate i.e. 9.6%.
(i) (a) Calculation of share price when dividend is declared :
P1 + D1
P0 =
1+ K e
P1 + 6.4
120 =
1 + 0.096
120 × 1.096 = P 1 + 6.4
P 1 = 120 × 1.096 – 6.4
= 125.12
(b) Calculation of share price when dividend is not declared :
P1 + D1
P0 =
1+ K e
P1 + 0
120 =
1 + 0.096
120 × 1.096 = P 1 + 0
P 1 = 131.52
(ii) Calculation of No. of shares to be issued:
(` in lakhs)
Particulars If dividend If dividend not
declared declared
Net Income 160 160
Less: Dividend paid 51.20 ------
Retained earnings 108.80 160
Investment budget 320 320
Amount to be raised by issue of new shares (i) 211.20 160
Market price per share (ii) 125.12 131.52
No. of new shares to be issued (ii) 1,68,797.95 1,21,654.50
Or say 1,68,798 1,21,655

Question 19
ABC Ltd. has 50,000 outstanding shares. The current market price per share is ` 100 each. It
hopes to make a net income of ` 5,00,000 at the end of current year. The Company’s Board is
considering a dividend of ` 5 per share at the end of current financial year. The company
needs to raise ` 10,00,000 for an approved investment expenditure. The company belongs to
a risk class for which the capitalization rate is 10%. Show, how the M-M approach affects the
value of firm if the dividends are paid or not paid.
Answer
When dividends are paid
100 = (5 + P 1 )/(1 + 0.10)
Therefore, P1 = ` 105/-.
Value of firm
D +P
P0= 1 1
1+ k
50000 × 5 + 50000 × 105 250000 + 5250000
= = = ` 50,00,000
1+ 0.10 1.10
When dividend is not paid
100 = 1/1.1 x P 1
Therefore, P1 = ` 110/-.
Value of firm
50000 × 0 + 50000 × 110 0 + 5500000
= = = ` 50,00,000/-
1+ 0.10 1.10
M.M. Approach indicates that the value of the firm in both the situations will be the same.
Question 20
M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has 25,000
outstanding shares and the current market price is ` 100. It expects a net profit of ` 2,50,000
for the year and the Board is considering dividend of ` 5 per share.
M Ltd. requires to raise ` 5,00,000 for an approved investment expenditure. Show, how the
MM approach affects the value of M Ltd. if dividends are paid or not paid.
Answer
A When dividend is paid
(a) Price per share at the end of year 1

1
100 = (` 5 + P 1)
1.10
110 = ` 5 + P1
P1 = 105
(b) Amount required to be raised from issue of new shares
` 5,00,000 – (` 2,50,000 – ` 1,25,000)
` 5,00,000 – ` 1,25,000 = ` 3,75,000
(c) Number of additional shares to be issued
3,75,000 75,000
= shares or say 3572 shares
105 21
(d) Value of M Ltd.
(Number of shares × Expected Price per share)
i.e., (25,000 + 3,572) × ` 105 = ` 30,00,060
B When dividend is not paid
(a) Price per share at the end of year 1
P
100 = 1
1.10
P1 = 110
(b) Amount required to be raised from issue of new shares
`5,00,000 – 2,50,000 = 2,50,000
(c) Number of additional shares to be issued
2,50,000 25,000
= shares or say 2273 shares.
110 11
(d) Value of M Ltd.,
(25,000 + 2273) × `110
= ` 30,00,030
Whether dividend is paid or not, the value remains the same.
Question 21
RST Ltd. has a capital of ` 10,00,000 in equity shares of ` 100 each. The shares are currently
quoted at par. The company proposes to declare a dividend of ` 10 per share at the end of the
current financial year. The capitalization rate for the risk class of which the company belongs
is 12%. What will be the market price of the share at the end of the year, if
(i) a dividend is not declared ?
(ii) a dividend is declared ?

(iii) assuming that the company pays the dividend and has net profits of `5,00,000 and
makes new investments of `10,00,000 during the period, how many new shares must be
issued? Use the MM model.
Answer
As per MM model, the current market price of equity share is:
1
P0 = × ( D1 + P1 )
1 + ke
(i) If the dividend is not declared:
1
100 = (0 + P1 )
1 + 0.12
P1
100 =
1.12
P1 = `112
The Market price of the equity share at the end of the year would be `112.
(ii) If the dividend is declared:
1
100 = × (10 + P1 )
1 + 0.12
10 + P1
100 =
1.12
112 = 10 + P1
P1 = 112 – 10 = `102
The market price of the equity share at the end of the year would be `102.
(iii) In case the firm pays dividend of `10 per share out of total profits of ` 5,00,000 and
plans to make new investment of ` 10,00,000, the number of shares to be issued may be
found as follows:
Total Earnings `5,00,000
- Dividends paid 1,00,000
Retained earnings 4,00,000
Total funds required 10,00,000
Fresh funds to be raised 6,00,000
Market price of the share 102

Number of shares to be issued (`6,00,000 / 102) 5,882.35

or, the firm would issue 5,883 shares at the rate of `102
Question 22
In December, 2011 AB Co.'s share was sold for ` 146 per share. A long term earnings growth
rate of 7.5% is anticipated. AB Co. is expected to pay dividend of ` 3.36 per share.
(i) What rate of return an investor can expect to earn assuming that dividends are expected
to grow along with earnings at 7.5% per year in perpetuity?
(ii) It is expected that AB Co. will earn about 10% on book Equity and shall retain 60% of
earnings. In this case, whether, there would be any change in growth rate and cost of Equity?
Answer
(i) According to Dividend Discount Model approach the firm’s expected or required return on
equity is computed as follows:
D1
e =
K + g
P0
Where,
Ke = Cost of equity share capital
D1 = Expected dividend at the end of year 1
P0 = Current market price of the share.
g = Expected growth rate of dividend.
3.36
Therefore, K e = + 7.5%
146
= 0.0230 +0.075 = 0.098
Or, Ke = 9.80%
(ii) With rate of return on retained earnings (r) 10% and retention ratio (b) 60%, new growth
rate will be as follows:
g= br i.e.
= 0.10 X 0.60 = 0.06
Accordingly dividend will also get changed and to calculate this, first we shall calculate
previous retention ratio (b1) and then EPS assuming that rate of return on retained
earnings (r) is same.
With previous Growth Rate of 7.5% and r =10% the retention ratio comes out to be:
0.075 =b1 X 0.10
b1 = 0.75 and payout ratio = 0.25

With 0.25 payout ratio the EPS will be as follows:

3.36
= 13.44
0.25
With new 0.40 (1 – 0.60) payout ratio the new dividend will be
D1 = 13.44 X 0.40 = 5.376
Accordingly new Ke will be
5.376
Ke = + 6.0%
146
or, Ke = 9.68%
Exercise
Question 1
CMC plc has an all-common-equity capital structure and has 200,000 shares of £2 par value equity
shares outstanding. When CMC’s founder, who was also its research director and most successful
inventor, retired unexpectedly to the South Pacific in late 2009, CMC was left suddenly and
permanently with materially lower growth expectations and relatively few attractive new investment
opportunities. Unfortunately, there was no way to replace the founder’s contributions to the firm.
Previously, CMC found it necessary to plough back most of its earnings to finance growth, which
averaged 12% per year. Future growth at a 5% rate is considered realistic; but that level would call for
an increase in the dividend payout. Further, it now appears that new investment projects with at least
the 14 % rate of return required by CMC’s shareholders (ke = 14%) would amount to only £800,000 for
2010 in comparison to a projected £2,000,000 of net income. If the existing 20% dividend payout were
continued, retained earnings would be £16,00,000 in 2010, but, as noted, investments that yield the 14
% cost of capital would amount to only £800,000.
The one encouraging thing is that the high earnings from existing assets are expected to continue, and
net income of £20,00,000 is still expected for 2010. Given the dramatically changed circumstances,
CMC’s board is reviewing the firm’s dividend policy.
(a) Assuming that the acceptable 2010 investment projects would be financed entirely by earnings
retained during the year, calculate DPS in 2010, assuming that CMC uses the residual payment policy.
(b) What payout ratio does your answer to part (a) imply for 2010?
(c) If a 60% payout ratio is adopted and maintained for the foreseeable future, what is your estimate
of the present market price of the equity share? How does this compare with the market price that
should have prevailed under the assumptions existing just before the news about the founder’s
retirement? If the two values of P0 are different. Comment on why?
(d) What would happen to the price of the share if the old 20% payout were continued? Assume that
if this payout is maintained, the average rate of return on the retained earnings will fall to 7.5%
and the new growth rate will be
G = (1.0- Payout ratio) × (ROE)

= (1.0 – 0.2) (7.5%) = (0.8) (7.5%) = 6.0%

Answer: (a) DPS =£6 = D1 (b) 60% (c) £ 66.67 (d) If the payout ratio were continued at 20%, even
after internal investment opportunities had declined, the price of the stock would drop to £25 rather
than to £66.67.
Question 2
Zumo & Co. is a watch manufacturing company and is all equity financed and has paid up capital
`10,00,000 (`10 per shares)
The other data related to the company is as follows:
Year EPS (`) Net Dividend per share (`) Share Price (`)
2004 4.20 1.70 25.20
2005 4.60 1.80 18.40
2006 5.10 2.00 25.50
2007 5.50 2.20 27.50
2008 6.20 2.50 37.20
Zumo & Co. has hired one management consultant, Vidal Consultants to analyze the future earnings
and other related item for the forthcoming years.
As per Vidal Consultant’s report
(1) The earnings and dividend will grow at 25% for the next two years.
(2) Earnings are likely at rate of 10% from 3rd year and onwards.
(3) Further if there is reduction in earnings growth occurs dividend payout ratio will increase to 50%
Assuming the tax rate as 33% (not expected to change in the foreseeable future) calculate the
estimated share price and P/E Ratio which analysts now expect for Zumo & Co., using the dividend
valuation model.
You may further assume that post tax cost of capital is 18%.
Answer: Expected Market Price of Share ` 53.34 and PE Ratio= 8.6
Question 3
Truly Plc presently pay a dividend of £1.00 per share and has a share price of £ 20.00.
(i) If this dividend were expected to grow at a rate of 12% per annum forever, what is the firm’s
expected or required return on equity using a dividend-discount model approach?
(ii) Instead of this situation in part (i), suppose that the dividends were expected to grow at a rate of
20% per annum for 5 years and 10% per year thereafter. Now what is the firm’s expected, or
required, return on equity?
Answer: (i) Ke = 17.6% (ii) Ke = 18.10%

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4

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

Where, p = Market price per share,

Vc = Market value of the share

© The Institute of Chartered Accountants of India

(i) (ii) (iii)

DP ratio 50% DP ratio 75% DP ratio 100%

(a) Price of Share if ⎛ .15 ⎞ ⎛ .15 ⎞ ⎛ .15 ⎞

` 125 ` 112.5 ` 100

© The Institute of Chartered Accountants of India

(b) Price of Share if ⎛ .10 ⎞ ⎛ .10 ⎞ ⎛ .10 ⎞

(c) Price of Share if ⎛ .05 ⎞ ⎛ .05 ⎞ ⎛ .05 ⎞

© The Institute of Chartered Accountants of India

36.25 Ke2 = 1.80 Ke + 0.64

-1.80 ± (1.80)2 - 4 × (-36.25) × 0.64

−1.80 ± 3.24 + 92.80

© The Institute of Chartered Accountants of India

Price estimate after budget announcement:

© The Institute of Chartered Accountants of India

and market price would be-

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

P1 = Market price of share at the year-end (to be determined)

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

Number of shares to be issued (`6,00,000 / 102) 5,882.35

© The Institute of Chartered Accountants of India

With 0.25 payout ratio the EPS will be as follows:

© The Institute of Chartered Accountants of India

= (1.0 – 0.2) (7.5%) = (0.8) (7.5%) = 6.0%

© The Institute of Chartered Accountants of India

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