# Dividend Decisions – CA Inter FM Study Material

Dividend Decisions – CA Inter FM Study Material is designed strictly as per the latest syllabus and exam pattern.

## Dividend Decisions – CA Inter FM Study Material

Theory Questions

Question 1.
Following information relating to Jee Ltd. are given:

 Profit after tax : ₹ 10,00,000 Dividend payout ratio : 50% Number of Equity shares : 50,000 Cost of equity : 10% Rate of return on investment : 12%

(1) What would be the market value per share as per Walter’s Model?
(2) What is the optimum dividend payout ratio according to Walter’s Model and market value of equity share at that payout ratio? (5 Marks Nov 2018)
(1) Market value (P) per share as per Walter’s Model:
P (Market value of share) = $$\frac{\mathrm{D}+(\mathrm{E}-\mathrm{D}) \times \frac{\mathrm{r}}{\mathrm{K}_{\mathrm{e}}}}{\mathrm{K}_{\mathrm{e}}}$$ = $$\frac{10+(20-10) \times \frac{0.12}{0.10}}{0.10}$$ = ₹ 220.00
E (EPS) = ₹ 10,00,000 shares (PAT) ÷ 50,000 = ₹ 20

(2) 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 payout ratio decreases. Hence, the optimum dividend payout ratio in this case is Nil. So, at a payout ratio zero, the market value of company’s share will be:
P (Market value of share) = $$\frac{\mathrm{D}+(\mathrm{E}-\mathrm{D}) \times \frac{\mathrm{r}}{\mathrm{K}_{\mathrm{e}}}}{\mathrm{K}_{\mathrm{e}}}$$ = $$\frac{0+(20-0) \times \frac{0.12}{0.10}}{0.10}$$ = ₹ 240.00 Question 2.
The following information is supplied to you:
Tolal Earning : ₹ 40,00,000
Number of Equity Shares f of ₹ 100 each) : 4,00,000
Dividend Per Share : ₹ 4
Cost of Capita : 16%
Internal Rate of Return : 20%
Retention Ratio : 60%

Calculate the market price of a share of company by using:
(1) Walter’s Formula.
(2) Gordon’s Formula. (5 Marks May 2019)
(1) Market Price of Share (P) as per Walter’s Formula:
P (Market value of share) = $$\frac{\mathrm{D}+(\mathrm{E}-\mathrm{D}) \times \frac{\mathrm{r}}{\mathrm{K}_{\mathrm{e}}}}{\mathrm{K}_{\mathrm{e}}}$$ = $$\frac{4+(10-4) \times \frac{0.20}{0.16}}{0.16}$$ = ₹ 71.875
E (EPS) = ₹ 40,00,000 (Earning) ÷ 4,00,000 shares = ₹ 10

(2) Market Price of Share (P) as per Gordon’s Formula:
P0 (Market value of share) = $$\frac{\mathrm{D}_1}{\mathrm{~K}_{\mathrm{e}}-\mathrm{g}}$$ = $$\frac{4.00}{0.16-0.12}$$ = ₹ 100.00
G (Growth Rate) = b × r = 20% × .6 = 12% Question 3.
Following figures and information were extracted from the company A Ltd.
Earnings of the company : ₹ 10,00,000
Dividend paid : ₹ 6,00,000
No. of shares outstanding : 2,00,000
Price earnings ratio : 10
Rate of return on investment : 20%

You are required to calculate:
(1) Current market price of the share.
(2) Capitalization rate of its risk class.
(3) What should be the optimum payout ratio?
(4) What should be the market price per share at optimal payout ratio?
(use Walter’s model) (5 Marks Nov 2019)
(1) Current market price of share:
Current Market Price of Share = EPS × PE Ratio = $$\frac{10,00,000}{2,00,000}$$ × 10 = ₹ 50

(2) Capitalization rate of its risk class:
Capitalization rate (Ke) = 1/PE = 1/10 = 0.10

(3) Optimum payout:
r > Ke, Therefore dividend payout should be NiL

(4) Market Price of Share (P) as per Walter’s Formula as per optimal payout ratio:
P (Market price of share) = $$\frac{\mathrm{D}+(\mathrm{E}-\mathrm{D}) \times \frac{\mathrm{r}}{\mathrm{K}_{\mathrm{e}}}}{\mathrm{K}_{\mathrm{e}}}$$ = $$\frac{0+(5-0) \times \frac{0.20}{0.10}}{0.10}$$ = ₹ 100 Question 4.
The following figures are extracted from the annual report of RJ Ltd.:

 Net Profit ₹ 50 lakhs Outstanding 13% preference shares ₹ 200 lakhs No. of Equity shares 6 lakhs Return on Investment 25% Cost of capital i.e. (Ke) 15%

You are required to compute the approximate dividend payout ratio by keeping the share price at ₹ 40 by using Walter model? (5 Marks Nov 2020) Question 5.
The following information is taken from ABC Ltd.
Net Profit for the year : ₹ 30,00,000
12% Preference shares capital : ₹ 1,00,00,000
Equity share capital (Share of ₹ 10 each) : ₹ 60,00,000
Internal rate of return on investment : 22%
Cost of Equity capital : 18%
Retention ratio : 75%

Calculate the market price of the share using:
1. Gordon’s Model
2. Walter’s Model (5 Marks Jan 2021)
1. Calculation of Price of share as per Gordon model:
P0 = $$\frac{D_1}{\mathrm{~K}_{\mathrm{e}}-\mathrm{g}}$$ = $$\frac{3 \times 0.25}{0.18-0.165}$$ = ₹ 50

2. Calculation of Price of share as per Walter model:
P = $$\frac{\mathrm{D}+(\mathrm{E}-\mathrm{D}) \times \frac{\mathrm{r}}{\mathrm{K}_{\mathrm{e}}}}{\mathrm{K}_{\mathrm{e}}}$$ = $$\frac{0.75+(3-0.75) \times \frac{0.22}{0.18}}{0.18}$$ = ₹ 19.44

Working note:
(a) Growth = b × r = 22% × .75 = 16.50%

(b) EPS = (PAT – PD) ÷ Number of shares
= (30,00,000 – 12% of 1,00,00,000) ÷ 6,00,000 = ₹ 3

(c) DPS = EPS × Payout ratio = ₹ 3 × 25% = ₹ 0.75 Important Questions

Question 1.
AB Engineering Ltd. belongs to a risk class for which the capitalization rate is 10%. It currently has outstanding 10,000 shares selling at ₹ 100 each. The firm is contemplating the declaration of a dividend of ₹ 5 per share at the end of the current financial year. It expects to have a net income of ₹ 1,00,000 and has a proposal for making new investments of ₹ 2,00,000.

Required:
1. Calculate value of firm when dividends are not paid.
2. Calculate value of firm when dividends are paid.
1. Value of the firm when dividends are not paid:
Step 1: Calculate price at the end of the period:
P0 = $$\frac{\mathrm{P}_1+\mathrm{D}_1}{1+\mathrm{K}_{\mathrm{e}}}$$
₹ 100 = $$\frac{P_1+0}{1+0.10}$$ or P1 = ₹ 110

Step 2: No. of shares required to be issued: 2. Value of the firm when dividends are paid:
Step 1: Calculate price at the end of the period:
P0 = $$\frac{\mathrm{P}_1+\mathrm{D}_1}{1+\mathrm{K}_{\mathrm{e}}}$$
₹ 100 = $$\frac{P_1+5}{1+0.10}$$ or P1 = ₹ 105

Step 2: No. of shares required to be issued: Thus, it can be seen that the value of the firm remains the same in either Question 2.
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/Earnings ratio 12.5

Applying Walter’s Model:
1. Ascertain whether the company is following an optimal dividend policy.
2. Find out what should be the P/E ratio at which the dividend policy will have no effect on the value of the share.
3. Will your decision change, if the P/E ratio is 8 instead of 12.5?
1. Ke = $$\frac{1}{\mathrm{PE}}$$ = $$\frac{1}{12.5}$$ = 8%
r = $$\frac{\text { Total Earnings }}{\text { Total Funds }}$$ × 100 = $$\frac{2,00,000}{20,000 \text { Shares } \times 100 \text { per share }}$$ × 100 = 10%
r > Ke, Therefore as per Walter model optimum dividend payout is Nil and company is paying dividend to shareholders means company is not following optimum dividend policy.

2. 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.
Ke = r = 10%
PE = $$\frac{1}{\mathrm{KE}}$$ = $$\frac{1}{.10}$$ = 10 times

3. 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:
Ke = $$\frac{1}{\mathrm{KE}}$$ = $$\frac{1}{8}$$ = 12.5%
In such a situation Ke > r and optimum dividend payout will be 100%. Question 3.
With the help of following figures calculate the market price of a share of a company by using:
1. Walter’s formula
2. Dividend growth model (Gordon’s formula)

 Earning per share (EPS) ₹ 10 Dividend per share (DPS) ₹ 6 Cost of capital (k) 20% Internal rate of return on investment 25% Retention Ratio 40%

1. Walter’s formula:
P = $$\frac{\mathrm{D}+(\mathrm{E}-\mathrm{D}) \times \frac{\mathrm{r}}{\mathrm{K}_{\mathrm{e}}}}{\mathrm{K}_{\mathrm{e}}}$$ = $$\frac{6+(10-6) \times \frac{0.25}{0.20}}{0.20}$$ = ₹ 55

2. Gordon’s formula (Dividend Growth model):
P0 = $$\frac{\mathrm{D}_1}{\mathrm{~K}_{\mathrm{e}}-\mathrm{g}}$$ = $$\frac{6}{0.20-0.10}$$ = ₹ 60
G = b × r = 25% × .4 = 10% Question 4.
In May, 2020 shares of RT Ltd. was sold for ₹ 1,460 per share. A long term earnings growth rate of 7.5% is anticipated. RT Ltd. is expected to pay dividend of ₹ 20 per share.
(a) Calculate 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?
(b) It is expected that RT Ltd. will earn about 10% on retained earnings and shall retain 60% of earnings. In this case, Slate whether, there would be any change in growth rate and cost of Equity?
(a) Ke = $$\frac{\mathrm{D}_1}{\mathrm{P}_{\mathrm{o}}}$$ + g = $$\frac{20}{1,460}$$ + 7.5% = 8.87%

(b) With rate of return on retained earnings (r) 1096 and retention ratio (b) 60%, new growth rate will be as follows:
g (revised growth rate) = b × r = 0.10 × 0.60 = 0.06 or 696
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 × 0.10
b1 = 0.75 and payout ratio = 0.25
EPS = ₹ 20 ÷ 0.25 (.75 retention) = ₹ 80
Revised D1 = ₹ 80 × 0.40 = ₹ 32
Revised Ke = $$\frac{\mathrm{D}_1}{\mathrm{P}_{\mathrm{o}}}$$ + g = $$\frac{32}{1,460}$$ + 6% = 8.19% Question 5.
A&R Ltd. is a large-cap multinational company listed in BSE In India with a face value of ₹ 100 per share. The company is expected to grow 15% p.a. for next four year then 5% for an indefinite period. The shareholders expect 20% return on their share Investments. Company paid ₹ 120 as dividend per share for the FY 2020-21. The shares of the company traded at an average price of ₹ 3,122 on last day.

Find out the intrinsic value of per share and state whether shares are overpriced or underpriced.
Calculation of Present Value or Current Market Value or Intrinsic Value of Share

 Year Expected benefits PVF @ 20% DCF 1 120.00+ 15% = 7138.00 0.833 114.95 2 138.00 + 15% = 7158.70 p.694 110.14 3 158.70 + 15% = 7182.50 0.579 105.67 4 182.50 + 15% = 7209.88 0.482 101.16 (5 to ∞) P4 = ₹ 1,469.16 0.482 708.13 Present value of all future benefits or Intrinsic value of Share ₹ 1,140.05

P4 = $$\frac{\mathrm{D}_5}{\mathrm{~K}_{\mathrm{e}}-\mathrm{g}}$$ = $$\frac{209.88+5 \%}{20 \%-5 \%}$$ = ₹ 1,469.16
Intrinsic value of share is 1,140.05 as compared to latest market price of ₹ 3,122. Market price of a share is overpriced by ₹ 1,98 1.95.

Question 6.
The dividend payout ratio of H Ltd. is 40%. If the company follows traditional approach to dividend policy with a multiplier of 9, what will be the P/E ratio.
Since the dividend payout ratio is 40%
D = 40% of E i.e. 0.4 E
P = M (D + E/3) = 9 (D + E/3) = 9 (0.4E + E/3)
P = 9(0.4E + E/3) = 9$$\left(\frac{1.2 \mathrm{E}+\mathrm{E}}{3}\right)$$ = 3(2.2E) = 6.6E
P/E ratio = $$\frac{\mathrm{MPS}}{\mathrm{EPS}}$$ = $$\frac{\mathrm{P}}{\mathrm{E}}$$ = $$\frac{6.6 \mathrm{E}}{\mathrm{E}}$$ = 6.6 times Question 7.
Given the last year’s dividend is ₹ 9.80, speed of adjustment = 45%, target payout ratio 60% and EPS for current year ₹ 20.
Calculate cutretit year’s dividend using Linter’s model.