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)

Answer:

(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)

Answer:

(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:

P_{0} (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)

Answer:

(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 (K_{e}) = 1/PE = 1/10 = 0.10

(3) Optimum payout:

r > K_{e}, 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. (K_{e}) |
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)

Answer:

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)

Answer:

1. Calculation of Price of share as per Gordon model:

P_{0} = \(\frac{D_1}{\mathrm{~K}_{\mathrm{e}}-\mathrm{g}}\) = \(\frac{3 \times 0.25}{0.18-0.165}\) = ₹ 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.

Answer:

1. Value of the firm when dividends are not paid:

Step 1: Calculate price at the end of the period:

P_{0} = \(\frac{\mathrm{P}_1+\mathrm{D}_1}{1+\mathrm{K}_{\mathrm{e}}}\)

₹ 100 = \(\frac{P_1+0}{1+0.10}\) or P_{1} = ₹ 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:

P_{0} = \(\frac{\mathrm{P}_1+\mathrm{D}_1}{1+\mathrm{K}_{\mathrm{e}}}\)

₹ 100 = \(\frac{P_1+5}{1+0.10}\) or P_{1} = ₹ 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?

Answer:

1. K_{e} = \(\frac{1}{\mathrm{PE}}\) = \(\frac{1}{12.5}\) = 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 > K_{e}, 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 k_{e} would be equal to the rate of return (r) of the firm.

K_{e} = 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 K_{e} which is the inverse of P/E ratio, would be 12.5:

K_{e} = \(\frac{1}{\mathrm{KE}}\) = \(\frac{1}{8}\) = 12.5%

In such a situation K_{e} > 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% |

Answer:

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):

P_{0} = \(\frac{\mathrm{D}_1}{\mathrm{~K}_{\mathrm{e}}-\mathrm{g}}\) = \(\frac{6}{0.20-0.10}\) = ₹ 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?

Answer:

(a) K_{e} = \(\frac{\mathrm{D}_1}{\mathrm{P}_{\mathrm{o}}}\) + 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 (b_{1}) 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 = b_{1} × 0.10

b_{1} = 0.75 and payout ratio = 0.25

EPS = ₹ 20 ÷ 0.25 (.75 retention) = ₹ 80

Revised D_{1} = ₹ 80 × 0.40 = ₹ 32

Revised K_{e} = \(\frac{\mathrm{D}_1}{\mathrm{P}_{\mathrm{o}}}\) + 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.

Answer:

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 ∞) | P_{4} = ₹ 1,469.16 |
0.482 | 708.13 |

Present value of all future benefits or Intrinsic value of Share | ₹ 1,140.05 |

P_{4} = \(\frac{\mathrm{D}_5}{\mathrm{~K}_{\mathrm{e}}-\mathrm{g}}\) = \(\frac{209.88+5 \%}{20 \%-5 \%}\) = ₹ 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.

Answer:

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.

Answer:

D_{1} = D_{0} + [(EPS × Target payout) – D_{0}] × Af

= 9.80 + [(20 × 60%) – 9.80] × 0.45 = ₹ 10.79