Dividend and Valuation 30.

21

Solved Problems
P.30.1 (a) X company earns Rs 5 per share, is capitalised at a rate of 10 per cent and has a rate of return on
investment of 18 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 according to Walter?
(b) Omega company has a cost of equity capital of 10 per cent, the current market value of the firm
(V) is Rs 20,00,000 (@ Rs 20 per share). Assume values for I (new investment), Y (earnings) and D (dividends)
at the end of the year as I = Rs 6,80,000, Y = Rs 1,50,000 and D = Re 1 per share. Show that under the MM
assumptions, the payment of dividend does not affect the value of the firm.
30.22 Financial Management

Solution
r 0.18
D (E D) Rs 1.25 + ( Rs 5.0 Rs 1.25)
ke 0.10
(a) P = = = Rs 80
ke 0.10
This is not the optimum dividend payout ratio because Walter suggests a zero per cent dividend payout
ratio in situations where r > ke to maximise the value of the firm. At this ratio, the value of the share
would be maximum, that is, Rs 90.
(b) Value of the firm, when dividends are paid (MM assumptions):
1
(i) Market price of the share at the end of the year: P0 = (P D1 )
( 1 ke ) 1
( P1 Re 1 )
Rs 20 = = Rs 21 = P1
1.10
(ii) Amount required for new financing: I – (Y – nD1) = Rs 6,80,000 – (Rs 1,50,000 – Rs 1,00,000)
= Rs 6,30,000
Rs 6,30,000
(iii) Number of shares to be issued: = = 30,000 shares
Rs 21
1
(iv) Value of the firm: = [nD1 + (n + n)P1 – I + Y – nD1]
(1 ke )

Rs 1,00,000 + [(1,00,000 + 30,000) Rs 21] Rs 6,80,000 + Rs 1,50,000 Rs 1,00,000

= 20,00,000
1.10
(c) Value of the firm when dividends are not paid:
Zero
P1
(i) Market price of the share at the end of the year: Rs 20 = , Rs 22 = P1
1.10
(ii) Amount required for new financing: I – (Y – nD1) = Rs 6,80,000 – Rs 1,50,000 = Rs 5,30,000
Rs 5,30,000
(iii) Number of new shares to be issued = shares
Rs 22
1
(iv) Value of the firm: = [(n + n)P1 – I + Y]
1 ke

5,30,000
1,00,000 Rs 22 Rs 6,80,000 + Rs 1,50,000
22
= = Rs 20,00,000
1.10
Since the value of the firm is Rs 20,00,000, in both the situations when dividends are paid and when
dividends are not paid, dividend does not affect the value of the firm.
P.30.2 The Apex Company which earns Rs 5 per share, is capitalised at 10 per cent and has a return on
investment of 12 per cent. Using Walter’s dividend policy model, determine optimum dividend pay out ratio
and the price of the share at this pay out. It currently has 1,00,000 shares selling at Rs 100 each. The firm
is contemplating the declaration of Rs 5 as dividend at the end of the current financial year, which has just
begun. What will be the price of the share at the end of the year, if a dividend is not declared? What will it
be if it is paid? Answer these on the basis of Modigliani and Miller model and assume no taxes.
Solution
(a) (i) According to Walter’s formula, the optimum dividend payout ratio would be zero as r > ke because
the value of the share of the firm would be maximum.
 Dividend and Valuation 30.23

r
D (E D)
ke ( 0.12 / 0.10 ) ( Rs 5)
(ii) P= = Rs 60
ke 0.10
1
(b) (i) Price of the share when dividends are declared (MM assumptions): P = (D1 + P1)
(1 ke )
1
Rs 100 = (Rs 5 + P1), Rs 105 = P1
1.10
(Rs 0 + P1 )
(ii) Price of share when dividends are not declared: Rs 100 = or P1 = Rs 110
1.10
P.30.3 Expandent Ltd had 50,000 equity shares of Rs 10 each outstanding on January 1. The shares are currently
being quoted at par in the market. The company now intends to pay a dividend of Rs 2 per share for the
current calendar year. It belongs to a risk class whose appropriate capitalisation rate is 15 per cent. Using
Modigliani-Miller model and assuming no taxes, ascertain the price of the company’s share at it is likely to
prevail at the end of the year (a) when dividend is declared, and (b) when no dividend is declared. (c) Also,
find out the number of new equity shares that the company must issue to meet its investment needs of Rs 2
lakh, assuming a net income of Rs 1.1 lakh and also assuming that the dividend is paid.
Solution
D1 P1 Rs 2 + P1
(a) Price of the share, when dividends are paid: P0 = , Rs 10 = , Rs 9.5 = P1
(1 ke ) 1.15
P1
(b) Price of the share, when dividends are not paid: Rs 10 = , Rs 11.5 = P1
1.15
(c) Number of new equity shares to be issued:
I ( E nD1 ) Rs 2,00,000 (Rs 1,10,000 1,00,000)
n= = = 20,000 shares
P1 Rs 9.5
P.30.4 The Asbestos Company belongs to a risk class of which the appropriate capitalisation rate is 10 per
cent. It currently has 1,00,000 shares selling at Rs 100 each. The firm is contemplating the declaration of a Rs
6 dividend at the end of the current fiscal year, which has just begun. Answer the following questions based
on Modigliani and Miller model and the assumptions of no taxes.
(a) What will be the price of the shares at the end of the year, if a dividend is not declared? What will it
be if it is declared?
(b) Assuming that the firm pays dividend, has a net income of Rs 10,00,000 and makes new investments of
Rs 20,00,000 during the period, how many new shares must be issued?
Solution
D1 P1 P1 + Rs 6
(a) (i)Price of the share, when dividend is declared: , Rs 100 = , Rs 104 = P1
(1 ke ) 1.10
P1 0
(ii)Price of the share, when dividends are not paid: Rs 100 = , Rs 110 = P1
1.10
I (E nD1 )
(b) Number of new shares to be issued: =
P1
Rs 20,00,000 (Rs 10,00,000 6,00,000)
= = 15,385 shares
Rs 104
P.30.5 From the following information supplied to you, determine the theoretical market value of equity shares
of a company as per Walter’s model:
30.24 Financial Management

Earnings of the company Rs 5,00,000

Dividends paid 3,00,000
Number of shares outstanding 1,00,000
Price earning ratio 8
Rate of return on investment 0.15

Are you satisfied with the current dividend policy of the firm? If not, what should be the optimal dividend
payout ratio in this case?
Solution
r 0.15
D (E D) Rs 3 + ( Rs 5 Rs 3)
ke 0.125
P= = Rs 43.20
ke 0.125
No, we are not satisfied with the current dividend policy. The optimal dividend payout ratio, given the facts
of the case, should be zero.
Working Notes
(i) ke is the reciprocal of P/E ratio = 1/8 = 12.5 per cent
(ii) E = Total earnings Number of shares outstanding
(iii) D = Total dividends Number of shares outstanding
P.30.6 The earnings per share of a company is Rs 8 and the rate of capitalisation applicable is 10 per cent.
The company has before it, an option of adopting (i) 50, (ii) 75 and (iii) 100 per cent dividend pay out ratio.
Compute the market price of the company’s quoted shares 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.
Solution
(i) D/P ratio = 0.50 (ii) D/P ratio = 0.75 (iii) D/P ratio = 1
(a) Price of shares if r = 0.15
0.15 0.15 0.15
Rs 4 + ( Rs 8 Rs 4) Rs 6 + ( Rs 8 Rs 6) Rs 8 + ( Rs 8 Rs 8)
0.10 0.10 0.10
P= P= P=
0.10 0.10 0.10
= Rs 100 = Rs 90 = Rs 80
(b) Price of share if r = 0.10
0.10 0.10 0.10
Rs 4 + ( Rs 8 Rs 4) Rs 6 + ( Rs 8 Rs 6) Rs 8 + ( Rs 8 Rs 8)
0.10 0.10 0.10
P= P= P=
0.10 0.10 0.10
= Rs 80 = Rs 80 = Rs 80
(c) Price of share if r = 0.05
0.05 0.05 0.05
Rs 4 + ( Rs 8 Rs 4) Rs 6 + ( Rs 8 Rs 6) Rs 8 + ( Rs 8 Rs 8)
0.10 0.10 0.10
P= P= P=
0.10 0.10 0.10
= Rs 60 = Rs 70 = Rs 80
P.30.7 A closely-held plastic manufacturing company has been following a dividend policy which can maximise
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 period and alternative investment opportunities for the
shareholders. In the current year, the firm reports net earnings of Rs 5,00,000. It is estimated that the firm can
earn Rs 1,00,000 if the amounts are retained. The investors have alternative investment opportunities that will
yield them 10 per cent. The firm has 50,000 shares outstanding. What should be the D/P ratio of the company
if it wishes to maximise the wealth of the shareholders?
 Dividend and Valuation 30.25

Solution D/P ratio of the company should be zero because at this ratio, market price of the share would
be the maximum as shown by the following calculations:
r
P= D (E D ) / K e = [0 + 0.20/0.10 (Rs 10 – 0)]/0.10
Ke
= Rs 20/0.10 = Rs 200
Working Notes
r = (Rs 1,00,000/Rs 5,00,000) 100 = 20 per cent
E = Rs 5,00,000/50,000 = Rs 10
P.30.8 (i) From the following information supplied to
you, ascertain whether the firm’s D/P ratio is optimal Earnings of the firm Rs 2,00,000
Dividend paid 1,50,000
according to Walter. The firm was started a year ago
P/E ratio 12.5
with an equity capital of Rs 20 lakh.
Number of shares outstanding, 20,000 @ Rs 100 each. The firm is expected to maintain its current rate of
earnings on investment.
(ii) What should be the P/E ratio at which the dividend payout ratio 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?
Solution
(i) P = [Rs 7.5 + (0.10/0.08) (Rs 10 – Rs 7.5)]/0.08 = Rs 10.625/0.08 = Rs 132.81.
The firm’s D/P ratio is not optimal. At 75 per cent D/P ratio, the price per share is Rs 132.81. The zero
per cent D/P ratio would be optimum, as at this ratio the value of the share would be maximum as
shown in the following calculations:
P = [0 + (0.10/0.08) (Rs 10 – 0)]/0.08 = Rs 12.50/0.08 = Rs 156.25.
Working Notes
(a) Ke is the reciprocal of P/E ratio = 1/0.125 = 8 per cent
(b) EPS = Rs 2,00,000 20,000 = Rs 10
(c) ROI(r) = (Rs 2,00,000 Rs 20,00,000) 100 = 10 per cent
(ii) At P/E ratio of 10 times, D/P ratio would have no effect on the value of the share because at this rate
Ke = r.
(iii) Yes, the decision would change if the P/E ratio is 8. This implies that Ke is 12.5 per cent. Since Ke > r,
the 100 per cent dividend payout ratio would maximise the value of the share: P = [10 + (0.10/0.125)
(Rs 10 – Rs 10)]/0.125 = Rs 80. At all other D/P ratios, the value would be lower.
P.30.9 A textile company belongs to a risk-class for which the appropriate P/E ratio is 10. It currently has
50,000 outstanding shares selling at Rs 100 each. The firm is contemplating the declaration of Rs 8 dividend at
the end of the current fiscal year which has just started. Given the assumption of MM, answer the following
questions.
(i) What will the price of the share be at the end of the year: (a) if dividend is not declared, and (b) if it
is declared?
(ii) Assuming that the firm pays the dividend, has a net income ( y) of Rs 5,00,000 and makes new
investments of Rs 10,00,000 during the period, how many new shares must be issued?
(iii) What will the value of the firm be: (a) if dividend is declared, and (b) if dividend is not declared?
Solution
(i) (a) Price, P1, when dividend is not declared
P0 = (D1 + P1)/(1 + Ke) or Rs 100 = 0 + P1/(1 + 0.10) = Rs 110 = P1
(b) When dividend is declared
Price, P0 = (D1 + P1)/(1 + Ke) = Rs 100 = (Rs 8 + P1)/0.10 = Rs 102
(Contd.)
30.26 Financial Management

(Contd.)
(ii) (a) Amount required for new financing
= I – (Y – nD1) = Rs 10,00,000 – (Rs 5,00,000 – Rs 4,00,000) = Rs 9,00,000
(b) New shares to be issued
Dn = Rs 9,00,000/102
(iii) (a) Value of the firm (V) when dividend is declared
V = [nD1 + (n + n)P1 – I + Y – nD1] /(1 + Ke)
= [(Rs 4,00,000 + 102 (50,000 + (Rs 9,00,000/102)] – 10,00,000 + 5,00,000 – 4,00,000] /1.10
= Rs 55,00,000/1.10 = Rs 50,00,000.
(b) Value, when dividend is not declared
V = [(n + n)P1 – I + Y ] /(1 + Ke)
= [(50,000 + Rs 5,00,000/100) 110 – Rs 10,00,000 + Rs 5,00,000]/1.1
= [Rs 60,00,000 – Rs 10,00,000 + Rs 5,00,000]/1.10 = Rs 50,00,000.

P.30.10 The following information is supplied to you, about a company:

Earnings of the company Rs 15,00,000
Dividends paid 5,00,000
Number of issued shares 1,00,000
Price earnings ratio 10
Rate of return on investment (%) 15
(i) Determine the theoretical market price of the share.
(ii) Are you satisfied with the current dividend policy of the Firm? If not, what should be the optimal dividend
payment ratio in this case?
Solution
[Rs 5 ( 0.15/0.10 ) ( 15 5 )] Rs 5 1.5 ( 10 ) Rs 20
(i) P = = Rs 200
0.10 0.10 0.10
(ii) The Company’s D/P ratio is not optimal. At 33.33 per cent D/P ratio, the price per share is Rs 200. The
zero per cent D/P ratio would be optimum, as at this ratio the value of the share would be maximum
as shown below:
[ 0 0.15/0.10 ] [Rs 15 0 ] 1.5 [Rs 15 ]
P Rs 225
0.10 0.10
Working Notes
(a) Ke is the reciprocal of P/E ratio = 1/0.10 = 10 per cent.
(b) EPS = Rs 15,00,000 1,00,000 = Rs 15.
(c) DPS = Rs 5,00,000 1,00,000 = Rs 5.
P.30.11 Assume the Hypothetical Ltd expects a potential earnings after taxes of Rs 200 lakh next year. Its
target debt ratio is 30 per cent. The capital budgeting department of the company projects the likely capital
expenditure next year amounting to (i) Rs 100 lakh (ii) Rs 200 lakh and (iii) Rs 400 lakh. Determine the cash
dividends likely to be paid and dividend payout ratio at varying levels of investment requirement under the
residual dividend policy.
Solution
Dividends Paid and Dividend Payout Ratio Under Residual Dividend Policy (Amount in Rs lakh)
Particulars Size of Capital Budget
(1) (2) (3)
Capital expenditure Rs 100 Rs 200 Rs 400
Projected earnings after taxes 200 200 200
Target debt ratio (%) 30 30 30
Equity funds needed 70 140 280
Earnings available to pay dividends 130 60 Zero
Dividend payout ratio (%) 65 30 Zero