Examples on Gordon Model of Dividend policy

Example 1: Royal Ltd. has distributed a dividend at 21% on paid up share capital
of Rs. 50,00,000 of Rs. 10 each. The annual growth in dividend is expected at 3%.
The expected rate of return on capital is 16%. Calculate value of each share.

Solution:
Dividend this year = 50,00,000 * 21% = 10,50,000
D1 D (1  g )
Price of share = P0  P 
rg
0
rg

= 10,50,000 (1.03)
0.16 – 0.03

= Rs. 83,19,231

Price per share = 83,19,231 / 5,00,000 shares = Rs. 16.64

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Example 2: Vipul Ltd. is expected to grow at 6% per annum. The dividend

expected on the equity share in a year is Rs. 2. What is the price of the share if
required rate of return is 14%?

Solution:
D1
P0  = 2 = Rs. 25
rg 0.14 – 0.06

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Example 3: Good-luck Ltd. has paid dividend of Rs. 3.50 per share. The same is
growing at 10% p.a. and the equity capitalization rate of the company is 12%. Find
out the PE ratio if the EPS of the company is Rs. 7.

Solution:
D1
P0  = 3.50 (1.10) = Rs. 192.50
rg 0.12 – 0.10
 PE Ratio = Price / EPS = 192.50 / 7 = Rs. 27.50

Example 4: A company’s current price of share is Rs. 60 and dividend per share is
Rs. 4. It its capitalization rate is 12%. What is the dividend growth rate?

Solution:
D (1  g ) 60 = 4 (1 +g)
P0 
rg 0.12 – g

60 (0.12 –g ) = 4 + 4g
7.2 – 60g = 4 + 4g
3.2 = 64g
g = 3.2 / 64 =0.05 or 5%

Example 5: The shares of a chemical company are selling at Rs. 20 per share. The
firm had paid dividend Rs. 2 per share last year. The estimated growth of the
company is 5% per annum.
(a) Find the cost of capital
(b) Determine the estimated market price of the share is the growth rate of
the firm is rises to 8% and falls to 3%.

Solution:
D (1  g )
P0 
rg
r–g= D (1 +g )
P0
r = D (1 +g ) +g
P0
2 ( 1 + 0.05) + 0.05
20
2 (1.05) + 0.05 = 15.5%
20
If growth raise to 8% if growth falls to 3%
2.16 2.06
0.155 – 0.08 0.155 – 0.03

Rs. 28.8 Rs. 16.48

Example 6: An investor is currently holding 1000 shares of Super Ltd. presently

the company dividend Rs. 2 per share and the share is being sold at Rs. 25 in the
market. However, few factors are likely to change during the next year as below.
Particular Existing Revised
Risk free rate 12% 10%
Market risk Premium 6% 4%
Beta value 1.4 1.25
Expected growth rate 5% 9%

In your view, should he buy, sell or hold the shares?

Solution:
Using CAPM equation = r = RF + βi (RM – RF)
Existing = 12%+1.4 (6%) = 20.4%
Revised = 10%+1.25 (4%) = 15%
Existing price = 2(1.05)/(0.204-0.05) = 2.10/0.154 = Rs. 13.63
Revised price = 2(1.09)/(0.15- 0.09) = 2.18/0.06 = Rs. 36.33
Examples on Walter model of Dividend policy

P= D + r/k (E – D)
k
D = DPS, E = EPS, r = IRR or ROI , k = cost of capital/ capitalization rate/ ROR to
share holders.

Example 1: Calculate the price of share by using Walter’s model

EPS Rs. 5
DPS Rs. 3
Cost of Capital 16%
IRR in investment 20%
Retention ratio 50%

Solution:
3 + 0.20/0.16 (5 – 3) = Rs. 34.37
0.16

Example 2: Guru & co. earns Rs. 6 per share having capitalization rate of 10%and
has ROI of 20%. As per the Walter’s model what should be price of the share at
30% dividend payout ratio? Is this the optimum ratio?

Solution:
Current dividend = Rs. 6* 30% = Rs. 1.8 per share

Applying the formula = 1.8 + 0.20/0.10 (6 – 1.8)

0.10

= 1.8 + (2 * 4.20) = Rs. 102

0.10

This is not the optimum ratio as r > k. The market price will further increase if the
payout rate is lower than 30%.
Example 3: The cost of capital and rate of return of a company is 10% and 15%
respectively. The company has one million shares of Rs. 10 each and its EPS is Rs.
5. Calculate the value of the firm using Walter model if company has (i) 100%
retention (ii) 50% retention and (iii) no retention.

Solution:
(i) 100% retention
0 + 0.15 / 0.10 (5 – 0) = Rs. 75
0.10

Value of the firm = Price per share * no. of share

= 75 * 10,00,000 = Rs. 750 lakhs
(ii) 50% retention
2.5 +0.15 / 0.10 (5 – 2.5) = Rs. 62.5
0.10

Value of the firm = 62.5 * 10,00,000 = Rs. 625 lakhs

(iii) no retention
5+ 0.15 / 0.10 ( 5 – 5) = Rs. 50
0.10

Value of the firm = 50 * 10,00,000 = Rs. 500 lakhs

Example 4: Following are the details of three companies.

A Ltd. B Ltd. C Ltd.
Internal Rate of Return 15% 5% 10%
Cost of Equity 10% 10% 10%
EPS Rs. 8 Rs. 8 Rs. 8

Calculate the value of equity shares of these companies by using Walter Model if
the dividend payout ratio is 50%, 75% and 25%.
Solution:
A Ltd. B Ltd. C Ltd.
(i) D/P 50% Rs. 100 Rs. 60 Rs. 80
(ii) D/P 75% Rs. 90 Rs. 70 Rs. 80
(iii) D/P 25% Rs. 110 Rs. 50 Rs. 80
Examples on MM model of Dividend policy

P0 = P1 + D1
1 + Ke
Where,
P0 = Prevailing market price of a share
P1 = Market Price of a share at the end of the period one
D1 = Dividend to be received at the end of period one
Ke = Cost of equity capital

ΔN = I – (E - nD1)
P1
Where,
ΔN = Change in the number of shares outstanding during the period.
I = Total Investment amount required for capital budget
E = Earning of net income of the firm during the period
n = Number of shares outstanding at the beginning of the period
D1 = Dividend to be received at the end of period one
P1 = Market price of a share at the end of period one

Example 1: XYS Ltd. has a share capital of Rs. 10,00,000 of Rs. 100 each. The share
are currently quoted at par. The company proposes declaration of dividend of Rs.
10 each. The capitalization rate of the company is 12%. What will be the market
price of the shares at the end of the year if (a) no dividend is declared (b) 10%
dividend is declared.
Assuming that the company pays the dividend and has a net profit of Rs. 5,00,000
and makes a new investment of Rs. 10,00,000. How many new shares must be
issued?

Solution:
(a) no dividend is declared
100 = P1 + 0 = 100 * 1.12 = P1 = Rs. 112
1 + 0.12
(b) when 10% dividend is declared
100 = P1 + 10 = 100 * 1.12 = P1 +10 = 112 – 10 = Rs. 102
1 + 0.12
Calculation of number of new shares to be issued.
Particular No dividend dividend
Net income 5,00,000 5,00,000
Less: Dividend 00 1,00,000
Retained earning 5,00,000 4,00,000
New investment 10,00,000 10,00,000
Amt. to be raised thru new shares (i) 5,00,000 6,00,000
Market price per share (ii) 112 102
New share to be issued (i / ii) 4464 5882

Using the formula to new share issue.

ΔN = I – (E - nD1)
P1

(a) When no dividend is declared

= 10,00,000 - (5,00,000 – 10,000 * 0) = 4464
112

(b) when dividend is declared

= 10,00,000 - (5,00,000 – 10,000 * 10) = 5882
102

Cross check
Particulars no dividend dividend
Existing shares 10,000 10,000
Add: New shares 4,464 5,882
Total share after a year (i) 14,464 15,882
Price per share (ii) 112 102
Total market value of share (i * ii) 16,19,968 16,19,964

Thus, as per Modigliani and Miller (MM) model, the total market value of the
shares will remain same if company pays or does not pay the dividend.
Example 2: ABC Ltd. has 50,000 outstanding shares. The current market price of
the share is Rs. 100 per share. It hopes to make a net income of Rs. 5,00,000 at
the end of the year. The Board is considering a dividend of Rs.5 per share at the
end of current financial year. The company needs to raise Rs. 10,00,000 for an
approved investment expenditure. The company’s capitalization rate is 10%.
Show, how does the MM Approach affect the value of the firm if the dividend are
paid or not.

Solution:
(a) If dividend is declared
100 = P1 + 5 = 110 – 5 = P1 = Rs. 105
1 + 0.10

(b) If dividend is not declared

100 = P1 + 0 = P1 = Rs. 110
1 + 0.10

Calculation of numbers of new shares

Particular dividend no dividend
Net income 5,00,000 5,00,000
Less: Dividend 2,50,000 00
Retained earning 2,50,000 5,00,000
New investment 10,00,000 10,00,000
Amount required to be raised 7,50,000 5,00,000
Price of the share 105 110
Number of new shares 7143 4545

Cross check
Existing shares 50,000 50,000
Add: New shares 7,143 4,545
Total shares (i) 57,143 54,545
Price per share (ii) 105 110
Total market value ( i X ii) 60 lakhs 60 lakhs
Example 3: Fast Auto Ltd. has outstanding 1,20,000 shares selling at Rs. 20 per
share. The company hopes to make a net income of Rs. 3,50,000 during the year
ended March 2011. The company is considering paying a dividend of Rs.2 per
share at the end of current year. The capitalization rate of the risk class of this
company is 15%.
(A) What will be price of the share at the end of 31 March, 2010 if dividend is paid
and if dividend is not paid?
(B) How many new share the company must issue if the dividend is paid and
needs Rs. 7,40,000 for the investment during the year?

Solution:

Price if dividend paid = Rs. 21

Price if dividend is not paid = Rs. 23

Number of new shares to be issued = 30,000

Examples from GTU Question Papers

Example 1 (May 12): A large sized chemical company has been expected to grow
at 14 per cent per year for the next 4 years and then to grow indefinitely at the
same rate as that of the national economy, that is, 5 per cent. The required rate
of return on the equity shares is 12 per cent. Assume that the company paid a
dividend of Rs 2 per share last year. Determine the market price of the shares
today.

Example 2 (Jan 13): The following information is available for Premji Company:

Earnings per share Rs. 5

Rate of return required by shareholders 16%
Assuming that the Gordon Valuation model holds, what rate of return should be
earned on investments to ensure that the market price is Rs. 50 when the
dividend payout is 40%.

Example 3 (Jan 13): The following information is available for Avanti Corporation.
Earnings per share Rs. 4
Rate of Return on investments 18%
Rate of Return required by shareholders 15%

What will be the price per share as per the Walter Model if the payout ratio is
40%, 50% and 60%?

Example 4 (May 13) – Same as example 1: The current dividend on an equity

share of Maxim Limited is Rs.4.00.Assume that Maxim’s dividend will grow at the
rate of 18 percent per year for the next 5 years. Thereafter, the growth rate is
expected to fall and stabilize at 10 percent. Equity investors require a return of
15 percent from Maxim’s equity shares. What is the intrinsic value of Maxim’s
equity share?

Example 5 (May 13): X Ltd. has 8 lakh equity shares outstanding at the beginning
of the current year. The current market price per share is Rs. 120. The Board of
directors of the company is contemplating Rs. 6.4 per share as dividend. The rate
of capitalization, appropriate to the risk-class to which the company belongs, is
9.6 per cent.

(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 Rs. 3.20 crore by the end of the year
assuming net income for the year will be Rs. 1.60 crore?
Example 6 (May 13) Same as example 3: The EPS of a company is Rs. 16. The
market capitalization rate applicable to the company is 12.5 per cent. Retained
earnings can be employed to yield a return of 10 per cent. The company is
considering a pay-out of 25 per cent, 50 per cent and 75 per cent. Which of these
would maximize the wealth of shareholders as per Walter’s model?

Example 7 (May 14): From the below information calculate the value of shares by
using Gordon Dividend Model if Retention Ratio is 60% and if retention ratio is
10%.

EPS = 10 Rs.
Cost of capital = 10%
Rate of Earning = 15%