CHAPTER- 2

DIVIDEND DECISIONS

Dr. Priya Gupta

• The term ‘dividend’ refers to that portion of profit (after tax) which is
distributed among the owners/shareholders of the firm.
• The profit which is not distributed is known as retained earnings.

• Dividend Policy determines the proportion of total earnings which is to be paid

as dividends and the proportion to be retained in the business for reinvestment
purposes.
• Dividend decision links the Investment decision with the Financing Decision.
• Higher dividends Smaller retained earnings More reliance on external
funds.

• As the objective of Financial Management is to maximize the market value of

equity, impact of dividend policy on value of firm has to be analysed.

• There are conflicting opinions about the impact of dividends on the value of the
firm.
– Relevance of Dividend decisions
– Irrelevance of Dividend decisions
Measuring Dividends
• Dividend Per Share (DPS)= Total Dividend
No. of Equity Shares outstanding
Rs. 10 Lacs
= =Rs 10 per share
1 Lac shares

• Dividend Yield = Dividend per Share

Current Market Price per Share
Rs. 5.50
= =10%
Rs.
55.00
• Dividend Payout ratio= Dividend per Share
Earnings per Share
Rs. 5.50
= 50%
Rs. 11.00
Forms of Dividends
1. Cash Dividend: Companies mostly pay dividends in cash.
– Regular, special, and interim dividends
– Have liquidity issues.
2. Stock Dividend (Bonus Shares): Issue of shares free of cost to the existing shareholders of
the company.
– Represents the capitalization of reserves.
– Proportionate shareholding remains the same, while shareholding of each shareholder increases.
– In India, bonus shares cannot be issued in lieu of cash dividends.
– Bonus Debentures: HLL issued (1:1) debentures on bonus (free) basis (2001)
Equity Capital Before Bonus Equity Capital After 1:1 Bonus
Paid-up Equity Rs. 1,000/- Paid-up Equity Rs. 2,000/-
(100 shares of Rs. 10/- each) (200 shares of Rs. 10/- each)
Reserves Rs. 5,000/- Reserves Rs. 4,000/-
Total Equity Capital Rs. 6,000/- Total Equity Capital Rs. 6,000/-
Forms of Dividends
3. Share Repurchase: The company buys its own shares from its own
shareholders using company’s funds.
➢rewarding the shareholders as the repurchase is at a price higher than the
current market price
➢also a mode of capital restructuring

✓ Modes of Share Repurchase in India:

1. Tender Offer (Fixed Price Tender Offer)
2. Open Market Repurchase thru Book Building Process
(Reverse Book Building/ Dutch Auction)
3. Open Market Repurchase thru Stock Exchange
Tender Offer Method
✓ Firm fixes the no. of shares, buyback price & time period during which it
will buyback the securities.
✓ Shareholders willing to sell their shares are required to ‘tender’ them to the
company.
✓ In case the offer is oversubscribed, the firms buys on pro-rata basis.
Open Market Method –Thru Book Building
✓ Also called Dutch Auction method or Reverse Book Building process.

✓ Firmannounces the no. of shares, range of buyback prices & time period
during which it will buyback the securities.

✓ Firm, thereafter, invites bids from shareholders- no. of shares and price, within
the price band, at which the investors are willing to sell.

✓ Based on the bids received, the final price is decided (usually the highest price
at which the target no. of shares is achieved).
Open Market Method –Thru Book Building
Current Market Price Rs 530/- No. of
Investor Bid Price Shares
Price Band Rs 540 – 560/- A 550 10000
Target No. of Shares 2,00,000 B 555 2000
C 540 50000
D 545 7500
E 550 24000
F 540 80000
Bid Price No. of Shares Cum. G 550 6000
H 555 85000
540 134500 134500
I 540 4500
545 19500 154000 J 545 2500
550 46000 200000 K 550 1000

555 87000 287000 L 560 4500

M 545 9500
560 14500 301500 N 550 5000
301500 O 560 10000
Total Bids Received for 301500
8
Open Market Method –Thru Stock Exchange
✓ Firm authorizes a stock broker to buy the securities from the shareholders.
✓ Company buys securities thru’ that broker to effect the buyback programme.
Procedural Aspects of Dividends
• Board Resolution: Board of Directors at their board meeting adopt a resolution to pay
dividends.
• Shareholders’ approval: Board’s resolution has to be approved by the shareholders at the
Annual General Meeting.
• Record date: Upon approval of the resolution, the Company fixes a “Record date” – to freeze
the shareholders to whom dividends has to be paid.
• Dividend payment: Once the dividend is declared, dividend warrants must be posted within 30
days.
Announcement date Ex-Dividend Record date Payment date
2-3 weeks 2-3 days 3-4 weeks

Company approves Dividend is paid

Dividend to shareholders
Stock has to be bought Company closes
by this date for books and
investor (buyer) to records owners
receive dividends of stock
 Stock Splits
➢ Stock Splits: The par value of the shares is reduced, thereby increasing the no. of shares
outstanding. (Not a form of Dividend)
• If a company declares 50% stock split, a shareholder holding 2 shares would hold 3 shares
(3:2 split) after the split.
• 100% stock split means 2:1 split.
▪ Brings the market price within a popular price range.
• A share of Rs 1000/- is less affordable than Rs 100/- share.
▪ Increases the no.of shares, hence the liquidity of the stock.

Equity Capital Before Stock Split Equity Capital After 10 : 1 Split

Paid-up Equity Rs. 1,000/- Paid-up Equity Rs. 1,000/-
(100 shares of Rs. 10/- each) (1000 shares of Re. 1/- each)
Reserves Rs. 5,000/- Reserves Rs. 5,000/-
Total Equity Capital Rs. 6,000/- Total Equity Capital Rs. 6,000/-
 Impact of Stock Dividends on Market Price
• Stock Dividend: If a company declares 10% stock dividends, a shareholder would get 1 new
share for every 10 shares held.

Before After
Market Value of Assets (Rs. Mn) 400 400
No. of Equity Shares outstanding (in Mn) 10 11
Share Price (Rs. Per Share) 40 36.36

➢ Reverse Split: 1:10 reverse split means every 10 shares are replaced by 1 new share.
Impact of Stock Dividends/ Stock Splits
Example: The stock of Country Inn Hotels is currently trading at Rs. 20 per share. What would
happen to the stock price, if the company announces:
a. Stock dividend of 20%
b. 3:2 Stock Split
c. 1:3 Reverse Stock Spilt.
a. Stock dividend of 20% : 1 new share for 5 held
• Market Value of 5 Shares before stock dividend: 5*20 = 100
• No. of Shares after Stock Dividend: 5+1 = 6
• Market Value per share after Stock Dividend: 100/6 = Rs.16.67
b. 3:2 Stock Split : Shareholder holds 3 shares instead of 2shares
• Market Value of 2 Shares before stock spilt: 2*20 = 40
• No. of Shares after Stock Spilt: 3
• Market Value per share after Stock spilt: 40/3 = Rs.13.33
c. 1:3 Reverse Stock Split : Shareholder holds 1 share instead of 3shares
• Market Value of 3 Shares before Reverse Stock Spilt: 3*20 = 60
• No. of Shares after Reverse Stock Spilt: 1
• Market Value per share after Reverse Stock spilt: 60/1 = Rs.60.00
Empirical evidence of Dividend Policy
• Dividends tend to follow earnings

– As dividends are paid out of earnings.

• Dividends are ‘sticky’

– Reluctance of firms to raise dividends until they feel confident of

maintaining it and to cut dividends unless absolutely required.

• Dividends follow a smoother path than earnings

• Dividend policy tends to follow the life cycle of the firm

– Firms in high growth stage pay low/ no dividends, while stable firms with
large cash balances and fewer projects pay out higher dividends.
Dividend Decision - Overview of Theories
❑Under Perfect Markets
• Dividends have an impact on stock prices:
✓ Walter’s Model
✓ Gordon’s Model
• Dividends do not have any impact on stock prices:
✓ MM Dividend Irrelevance hypothesis

❑Under Market Imperfections

✓ Dividends are ‘Bad’
✓ Dividends are ‘Good’
 Under Perfect Market conditions

Dividends have an impact on stock prices

(Walter & Gordon Model)
DIVIDEND RELEVANCE: WALTER’S MODEL
• Professor James E. Walter argues that the choice of dividend policies almost
always affect the value of the firm.
• This model shows the importance of the relationship between the firm’s rate of
return, r, and its cost of capital, k, in determining the dividend policy that will
maximize the wealth of shareholders.

• Walter’s model is based on the following assumptions:

✓Internal financing: The firm finances all investments through retained earnings;
that is, debt or new equity is not issued.
✓Constant return and cost of capital: The firm’s rate of return, r, and its cost of
capital, k, are constant.
✓100% payout or retention: All earnings are either distributed as dividends or
reinvested internally immediately.
✓Constant EPS and DPS: Beginning earnings and dividends never change. The
value of earnings per share, EPS, and the dividend per share, DPS, may be
changed in the model to determine results, but any given values of EPS and DPS
are assumed to remain constant forever in determining a given value.
✓Infinite time: The firm has a very long or infinite life.
Dividend Relevance: Walter Model 1
• As per Walter’s Model, the market value of equity is the sum of Present Value of :
(a) Infinite stream of constant dividends, and
(b) Infinite stream of returns from retained earnings.

r
(E-D)
D k
P = +
k k
Present Value of infinite Present Value of infinite
stream of constant stream of returns from
Dividends retained earnings
where,
P = Market Price per share
D = Dividend per share
E = Earnings per share
r = firm’s average rate of return
k = firm’s cost of capital
1James Walter, “Dividend Policy: Its Influence on the Value of
the Firm”, Journal of Finance (May 1963)
Walter Model (Contd.)
Basic EPS Rs 20 Rs 20 Rs 20
Data
r 18% 14% 10%
k 14% 14% 14%
Payout (%) Case I Case II Case III
r>k r=k r<k
0% Rs 184 Rs 143 Rs 102
25% Rs 173 Rs 143 Rs 112
50% Rs 163 Rs 143 Rs 122
75% Rs 153 Rs 143 Rs 133
100% Rs 143 Rs 143 Rs 143
✓Case I (r > k): Growth Firms
• Growth firms are those firms which expand rapidly because of ample investment
opportunities yielding returns higher than the opportunity cost of capital.
• Firms are able to earn more than what the shareholders can earn on their own.
• Such firms should retain all of its profits i.e. Dividend payout ratio (D/P) should
be Zero, at which the Market Price shall be maximum.

✓Case II (r=k): Normal firms

• Normal firms earn on their investments rate of return equal to the cost of capital.
• Firm earns at a rate equal to the minimum hurdle rate (k).
• Such firms are indifferent, i.e., the dividend policy has no effect on the market
value per share.
✓Case III (r < k): Declining Firms
• Declining firms do not have any profitable investment opportunities to invest the
earnings.
• Firms do not have projects which can earn as much as the minimum hurdle rate (k).
• Such firms should distribute all its profits (D/P = 100%) for market Price to be
maximum.
Walter Model- Implications

Case I (r > k): Firm is able to earn more than what the shareholders can earn on
their own.
➢ Such firm should retain all of its profits i.e. Dividend payout ratio (D/P) should
be Zero, at which the Market Price shall be maximum.
Case III (r < k): Firm does not have projects which can earn as much as the
minimum hurdle rate (k).
➢ Such firm should distribute all its profits (D/P = 100%) for market Price to
be maximum.
Case II (r=k): Firm earns at a rate equal to the minimum hurdle rate (k).
➢ Such firm is indifferent.
Walter Model - Illustration
Excel Industries has reported an EPS of Rs. 10/-. It earns @ 15% on its assets while its cost of
capital is 12.5%. If Walter’s model is used, what should be the optimum dividend payout
policy? What would be the stock price? What would be the impact on stock price, if the dividend
payout is changed to 30%?

EPS = Rs. 10/- ; r =15%; k = 12.5%

• As r > k, the optimum dividend policy as per Walter’s model would be to retain 100%
of the earnings
• At D/P = 0%, the stock price would be:

(10- 0) 0.15
0 0.125 = Rs. 96/-
P = +
0 .1 2 5 0 .1 2 5
• If the payout is 30% (instead of 0%), the stock price would be:
0.15
(10- 3)
3 + 0.125 = 24 +67.20 = Rs. 91.20
P =
0 .1 2 5 0 .1 2 5
Criticism of Walter’s Model
• The financing of investment proposals only by retained earnings and no external
financing is seldom found in real life.
• The assumptions of constant ‘r’ and constant ‘k’, is also unrealistic and does not
hold good.
• As more and more investments are made, the risk complexion of the firm will
change and consequently the k may not remain constant.
DIVIDEND RELEVANCE: GORDON’S MODEL
• Myron Gordon has also proposed a model suggesting that the dividend policy
is relevant and can affect the value of the share and that of the firm.

• Gordon’s model is based on the following assumptions:

✓All equity firm: The firm is an all-equity firm, and it has no debt.
✓No external financing: No external financing is available. Consequently,
retained earnings would be used to finance any expansion.
✓Constant return: The internal rate of return, r, of the firm is constant.
✓Constant cost of capital: The appropriate discount rate, k, for the firm remains
constant.
✓Perpetual earnings: The firm and its stream of earnings are perpetual.
✓No taxes: Corporate taxes do not exist.
✓Constant retention: The retention ratio, b, once decided upon, is constant.
Thus, the growth rate, g = br, is constant forever.
✓Cost of capital greater than growth rate: The discount rate is greater than
growth rate, k > g. If this condition is not fulfilled, we cannot get a meaningful
value for the share.
Dividend Relevance: Gordon Model2
• Using the Dividend Discounting Model, Gordon
model states:
E1 (1-b)
P0=
where: k -b r
P0 = Price per share at T0
E1 = Earnings per share at T1
b = retention ratio
k = firm’s cost of capital
r = firm’s rate of return on investments

2 M.J.Gordon,“The Investment, Financing and Valuation of the

Corporation (1962)
Gordon Model (Contd.)

Basic Data EPS Rs 20 Rs 20 Rs 20

r 18% 14% 10%
k 14% 14% 14%
Retention Payout Case I r > Case II r = Case III r <
Ratio (b) Ratio(1-b) k k k
75% 25% Rs 1000 Rs 143 Rs 77
50% 50% Rs 200 Rs 143 Rs 111
25% 75% Rs 158 Rs 143 Rs 130
0% 100% Rs 143 Rs 143 Rs 143
▪ If r > k, price increases as dividend payout decreases
▪ If r < k, price increases as dividend payout increases
▪ If r = k, price remains unchanged
Walter & Gordon Models - Illustration
Excel Industries has reported an EPS of Rs. 10/-. Its cost of capital is 10% and retention ratio is
40%. Determine the price per share as per Walter model and Gordon Model if the company
earns @ 15%; 10% or 5%.

EPS = Rs. 10/- ; r=15%; 10%; 5%; k = 10%; b = 40% :DPS = (1- b)EPS =6

(E-D)r
E1 (1-b)
P0 ( Wa l t e r ) = D + k P0 ( G o r d o n ) =
k k k -b r

g Walter’s Model Gordon Model

0.40*0.15 = 6% 120 150
0.40*0.10 = 4% 100 100
0.40*0.05 =2% 80 75
 Under Perfect Market conditions

Dividends do not have any impact on stock prices

(MM Dividend Irrelevance Hypothesis)
DIVIDEND IRRELEVANCE: Modigliani & Miller’s
(MM) Hypothesis
• Value of the firm depends upon the earning power of the firm’s assets or its
Investment policy.
• The manner in which the earnings are split between dividends and retained
earnings does not effect the value of the firm.
• Assumptions of MM Hypothesis:
– Perfect Capital Markets – Investors are rational
– No flotation costs
– No taxes
– No change in the given investment policy
Dividends in MM’s world of Perfect Capital Markets
• Modigliani & Miller (MM) hypothesized irrelevance of Dividends under assumptions of
Perfect Capital Markets.
➢ Consider an unlevered company which has :
▪ Rs 20 Mn of excess cash,
▪ 10 Mn equity shares outstanding & cost of capital of 12%,
▪ Firm expects to generate additional free cash flows of
Rs 48 Mn per year in subsequent years.
➢ The value of the firm, today, would be the present value of the future cash flows (till
perpetuity) + excess cash:
FCF 48
V0 = + cash = + 20 = Rs. 420 Mn
k 0.12
Dividends in MM’s world of Perfect Capital Markets

➢ The company has 3 options:

• Pay Cash dividend out of excess cash
• Repurchase equity instead of paying Dividends
• Pay higher Dividends (& Raise additional cash to pay)
1. Pay Dividend out of excess Cash
• The company may decide to distribute Rs 20 Mn excess cash as dividends amongst its 10 Mn
shares i.e. pay Rs. 2 per share as dividends.
• In future, as the company would generate Rs 48 Mn of free cash flows each year, it may
expect to pay dividend of Rs. 4.80 per share each year.
• Fair price is the present value of future dividends.
• Price Before ex-dividend would be:
Pcum = Current Dividend + PV of Future Dividends
4.80
=2+ = 2 + 40 = Rs. 42/-
0.12
• Price After ex-dividend would be (buyer will not get the current dividend):

Pex = PV of Future Dividends = 4.80 = Rs. 40/-

0.12
• The stock price will fall on ex-dividend date by the amount of dividend.
1. Pay Dividend out of excess Cash
Cum-Dividend Ex-Dividend

1. Cash (Rs. Mn) 20 0

2. Market Value of other assets (Rs. Mn) 400 400

3. Total Assets (Rs. Mn) 420 400

4. No. of Shares (Mn) 10 10

5. Market Price per share (Rs. per share) (3 / 4) 42 40

• The price falls when dividend is paid, as such payment reduces the market value of the
firm’s assets.
• Thus, in perfect capital markets, when dividend is paid, the share price drops by the
amount of dividends when the stock begins to trade ex-dividend.
• But the company’s shareholder does not incur a loss.
• Before dividends, the market price was Rs. 42/- while after the dividend payout , the market
price is Rs. 40/- and has Rs 2/- in cash as well.
2. Repurchase equity (instead of Dividend)
• Now, assume the company does not pay dividends but instead repurchases its equity in the
open market.
• How will repurchase affect the share price?
• With initial price of Rs. 42/- per share, the firm would be able to buy 0.476 Mn shares (Rs.
20 Mn/Rs. 42 ) out of 10 Mn shares.

Before Repurchase After Repurchase

1. Cash (Rs. Mn) 20 0
2. Market Value of other assets (Rs. Mn) 400 400
3. Total Assets (Rs. Mn) 420 400
4. No. of Shares (Mn) 10 10 - 0.476 = 9.524
5. Market Price per share (Rs. per share) (3/4) 42 400/9.524 = 42

• Although the market value of assets fall, but the no. of shares outstanding also falls, the
two changes offset each other, so there is no impact on the market value of the firm’s
equity shares.
2. Repurchase equity (instead of Dividend)
• In the future, the company expects to generate Rs. 48 Mn in free cash flows, which can be
used to distribute as dividends over 9.524 Mn shares (10 Mn – 0. 476 Mn) i.e. Rs. 5.04 per
share each year.
• Thus, the market price after repurchase would be:

5.04
Prep = = Rs. 42/-
0.12

• By not paying dividends today and repurchasing shares instead, the company is able to
increase the dividend per share in the future.
• Increase in future dividends compensates the shareholders for loss of dividends today.
• Thus, in perfect capital markets, an open market repurchase has no effect on the stock price
– price is same as Cum- dividend price if dividend was paid instead.
2. Repurchase equity (instead of Dividend)
• Does the Investors’ wealth change – between dividends and repurchase?
• Assume an investor holding 2000 shares and does not sell the shares, the wealth remains the
same in either of the options

If Co. pays Dividend of Rs. 2/- If Co. Repurchases Shares

Share Value Rs. 40 * 2000 = Rs 80,000/- Rs. 42 * 2000 = Rs 84,000/-
Cash Rs. 2 * 2000 = Rs 4000/- Nil
Total Wealth Rs 84,000/- Rs 84,000/-

• The only difference is the distribution between cash and stock holdings.
• Thus, investors would prefer between cash and stock holding depending on whether they
requires cash or not.
2. Repurchase equity (instead of Dividend)

• Case 1: If the firm repurchases stock and the investor needs cash, he would sell the
shares.
– Investor would sell 95 shares (Rs. 4000 / Rs. 42 per share) to raise Rs. 4000/- in cash.
– Investor would be left with 1905 shares(2000-95) valued at Rs. 80,000/- (@Rs.42/- per
share)
– Thus, in case of repurchase, by selling the shares, an investor can create a
homemade dividend
• Case 2: If the firm pays dividend but the investor does not require cash, the
investor can buy more shares out of the dividends received.
– Investor would buy 100 additional shares (Rs. 4000 / Rs 40 per share)out of the
dividend of Rs. 4000 received.
– Investors’ shareholding would be 2100 shares(2000 +100) valued at Rs. 84,000/-
(@Rs.40/- per share)
2. Repurchase equity (instead of Dividend)
• Investors’ position would be:
If Co. pays Dividend & Shareholder does not If Co. Repurchases shares & Shareholder
require Cash requires Cash (Sell 95 shares)
(Buy 100 shares)
Stock 2100 @ Rs. 40 = Rs 84,000/- 1905 @ Rs. 42 ≈ Rs 80,000/-
Cash - 95 @ Rs. 42 ≈ 4000
Total Rs 84,000/- Rs 84,000/-

• By reinvesting the dividends or selling shares, investor can create any combination of cash &
stock.
• Hence, the investor is indifferent between the two modes of rewards (returning cash).
• Thus, in perfect capital markets, investors are indifferent between the firm distributing funds
by dividends or share repurchase. By reinvesting dividends or selling shares they can replicate
either payout methods on their own.
3. Raise cash and pay high Dividend
• Now assume the company wants to pay larger dividend (higher than Rs 2 per share)
• Instead of paying Rs 48 Mn in dividends from next year onwards (as assumed earlier), it
wants to pay Rs 48 Mn now, but the company has only Rs 20 Mn of excess cash.
• Hence, the company needs to generate Rs 28 Mn in cash.
• Option 1: Give up +ve NPV projects worth Rs 28 Mn. This would lower the value of firm.
• Option 2: Raise cash by selling equity.
✓ At Rs 42 per share, the firm can raise Rs 28 Mn by selling 0.67 Mn shares
✓ No. of shares outstanding now would be 10.67 Mn & dividend per share would be Rs. 4.50 per share. (Rs 48
Mn / 10.67 Mn shares)
• Under the new policy, the cum-dividend price would be:

4.50
P cum = 4.50 + = 4.50 + 37.50 = Rs. 42/-
0.12
• Thus, increasing dividends also has no effect on stock price.
Modigliani – Miller Dividend Irrelevance
Dividend Policy Initial Year 0 Year 1 Year 2 …….
Price
1. Pay Dividends out of Excess Cash Rs. 42/- 2.00 4.80 4.80 …….
2. Repurchase Shares Rs. 42/- 0.00 5.04 5.04 ..….
3. Increase Dividends & raise cash Rs 42/- 4.50 4.50 4.50 …….

• If a firm lowers current dividends and repurchases shares, it will have fewer shares, and so
will be able to pay higher dividends in the future.
• If a firm pays higher current dividends by issuing equity, it will have more equity and hence
lower free cash flows and hence would be able to pay lower dividends in the future.

MM Dividend Irrelevance: In perfect capital market, holding the investment policy fixed, the
firm’s choice of a dividend policy does not effect the firm’s stock price, and therefore is
irrelevant.
Dividend policy when dividends are irrelevant
• The assumptions needed to arrive at the dividend irrelevance proposition are too restrictive
and we may be tempted to reject it.
• But the theory does contain valuable implications:
➢ A firm that has invested in bad project, cannot hope to increase its value by paying higher
dividends.
➢ A firm with great investments may be able to sustain its value even if it does not pay any
dividends.

Value of a firm is derived from its free cash flows. In a perfect

capital markets, dividends or repurchases do not matter.
In reality capital markets are not perfect.
As with Capital structure, it is the imperfections in capital markets
that should drive the dividend policy.
NUMERICAL QUESTIONS
FOR PRACTICE
1. Following are the details regarding three companies A Ltd., B Ltd. and C Ltd.:
A Ltd. B Ltd. C Ltd.
r = 15% r = 5% r = 10%
k = 10% k = 10% k = 10%
E = Rs 8 E = Rs 8 E = Rs 8

Calculate the value of an equity share of each of these companies applying

Walter’s model when dividend payout ratio is 25%, 50% and 75%.
What conclusions do you draw?
2. The earnings per share of a share of the face value of Rs 100 of PQR Ltd. is Rs 20.
it has a rate of return of 25%. Capitalization rate of its risk class is 12.5%. If
Walter’s model is used:
(a) What should be the optimum payout ratio?
(b) What should be the market price per share if the payout ratio is zero?
(c) Suppose, the company has a payout of 25% of EPS, what would be the price per
share?

3. The EPS of ABC Ltd. is Rs 10 and rate of capitalization applicable to it is 10%.

The company has the option of adopting a payout of 20% or 40% or 80%. Using
Walter’s formula, compute the market value of the company’s share if the
productivity of retained earnings is:
(i) 20%, (ii) 10%, or (iii) 8%
4. The EPS of a company is Rs 10. it has an internal rate of return of 15% and the
capitalization rate of its risk class is 12.5%. If Walter’s model is used –
(a) What should be the optimum payout ratio of the company?
(b) What would be the price of the share at this payout?
(c) How shall the price of the share be affected, if a different payout were
employed?
5. ABC Ltd. has been following a dividend policy which can maximize the
market value of the firm as per Walter’s model. Accordingly, each year, at
dividend time the capital budget is reviewed in conjunction with the earnings
for the periods and alternative investment opportunities for the shareholders.
In the current year, the firm expects earnings of Rs 5,00,000. It is estimated
that the firm can earn Rs 1,00,000 if the profits are retained. The investors have
alternative investment opportunities that will yield them 10% return. The firm
has 50,000 shares outstanding. What should be the dividend payout ratio in
order to maximize the wealth of the shareholders? Also find out the market
price of the share.
6. From the following information supplied to you, ascertain whether the firm is
following an optimal dividend policy as per Walter’s model?
Total earnings Rs 2,00,000
No. of equity shares (of Rs 100 each) 20,000
Dividend paid Rs 1,50,000
P/E ratio 12.5%
Rate of return, r 10%
The firm is expected to maintain its rate of return on fresh investment. Also find
out what should be the P/E ratio at which the dividend policy will have no effect
on the value of the share?
7. A company has total investment of Rs 5,00,000 assets and 50,000 outstanding
equity shares of Rs 10 each. It earns a rate of 15% on its investments, and has a
policy of retaining 50% of the earnings. If the appropriate discount rate for the
firm is 10%, determine the price of its share using Gordon Model. What shall
happen to the price, if the company has a payout of 80% or 20%?

8. Assuming that rate of return expected by investor is 11%; internal rate of return
is 12%; and earnings per share is Rs 15, calculate the price per share by Gordon
Approach if dividend payout ratio is 10% and 30%.
9. RST Ltd. has a capital of Rs 10,00,000 in equity shares of Rs 100 each. The
shares are currently quoted at par. The company proposes to declare a dividend
of Rs 10 per share at the end of the current financial year. The capitalization rate
for the risk class to 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 Rs.
5,00,000 and makes new investments of Rs. 10,00,000 during the period, how
many new shares must be issued using the MM Model?
10. Text Ltd. has 80,000 shares outstanding. The current market price of these
shares is Rs 15 each. The company expects a net profit of Rs 2,40,000 during
the year and it belongs to a risk class for which the appropriate capitalization
rate is 20%. The company is considering dividend of Rs 2 per share for the
current year.
(a) What will be the price of the share at the end of the year– if the dividend is
paid, and if the dividend is not paid?
(b) How many new shares must the company issue if the dividend is paid and
the company needs Rs 5,60,000 for an approved investment expenditure during
the year? Use MM Model for the calculation.