FM - Dividend Policy and Dividend Decision Models (Cir 18.3.2020)

Pillai Institute of Management Studies and
Research (PIMSR),
New Panvel
Master of Management Studies (MMS)
1
MMS – Semester - II
Subject : Financial Management (FM)
Chapter - 6 : Dividend Policy and

Dividend Decision Models
(Theory and Problems )
(Lecture date : 18.3.2020)
by
Dr. K.G.S.MANI
2
Lecture date : 18.3.2020
Chapter–6: Dividend Policy and Dividend Decision Models :
(1) Meaning of Dividend :
The term dividend refers to that part of the earnings (profits) of
a company which is distributed among its shareholders on the
basis of their shareholding. It is the reward to the
shareholders for their investments made in the company.
Generally the shareholders would prefer to receive higher rate
of dividend in relation to high risk undertaken by the equity
shareholders. But the company would prefer retention of profit
as a desirable decision because it provide funds for financing
the expansion and growth of the firms. Dividend is defined as
“a distribution to shareholders out of profits or reserves
available for this purpose”. Generally dividend may be paid at a
fixed percentage but this percentage may be changed every
year according to the level of profit earned by the Company.
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IMPORTANT CONCEPT : Higher Earnings per Share (EPS) ratio
increases the market price (MPS) of equity shares of the company
and low EPS decrease the market price of the share. Dividend
decision is treated as a residual or passive decision when the
company pays dividend only when it cannot profitably reinvest the
earnings in the business due to lack of profitable investment
opportunities.
Dividend decision is taken by the Board of Directors and is then
recommended to the shareholders for their final approval at Annual
General Meeting (AGM) of the company and only then dividend is
payable. The shareholders can reduce the amount of dividend even
to zero but can not increase the amount of dividend as
recommended by the Board of Directors. If the directors, decide
not to declare any dividend, shareholders in general meaning cannot
themselves declare it.
Briefly, Dividend Decision is whether to distribute the profits as
dividend to shareholders or to retain profits and reinvest in the
business partly or fully. However, the entire profit cannot be retained
in business but only partly, as ‘retained earnings’, after paying
dividend.
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(2) Dividend Policy :
Most of the companies follow certain principles for the declaration
of dividend. But dividend should be declared only out of divisible
profit. If the company incur loss at any particular year it shall not
distribute dividend in that year. Dividend Policy means it is the
policy of the company with regard to quantum of profits to be
distributed as dividend. The basic concept of the dividend policy is
that the company desires and takes any future action regarding the
payment of dividend as per the directives of Company Law Board
and Companies Act.
Definition :
Weston and Brigham defines dividend policy as “Dividend policy
determines the division of earnings between payment to
shareholders and retained earnings”.
Total distributable profit to equity shareholders, is known as
‘divisible profit’ and represents only the eligible amount available to
equity shareholders. Therefore, total distributable profit is equal to
(i) amount of dividend paid (plus) (ii) retained profit.
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(3) Factors affecting Dividend Payment :
(a) External Factors :
(1) General state of economy: In case of uncertain economic and

business conditions, the management may like to retain the
whole or a part of the firm’ earnings to build up reserves to
absorb the shocks in future.
(2) Legal restrictions: Companies Act 2013, have put several
restrictions regarding declaration and payment of dividends.
(3) Contractual restrictions: Lenders of the Company generally put
restrictions on dividend payments to protect their interests
during periods when the company is experiencing liquidity or
profitability problems.
(4) Tax Policy: Tax Policy followed by the government also affects
the dividends policy of the Company.
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(b) Internal factors :
(1) Desire of the shareholders : Directors of company have
considerable liberty regarding the disposal of the company’s
earnings, but the shareholders who are technically the owners
of the company, and therefore, their desire cannot be
overlooked by the directors while deciding about the dividend
policy.
(2) Financial needs of the company : Financial requirements for
expansion, diversification, long term investments are to be
considered by the management, while taking the dividend
decisions.
(3) Nature of earnings : A company having stable income can
afford to have a higher dividend pay-out ratio as compared to a
firm which does not have such stability in its earnings.
(4) Desire of control : Dividend policy is also influenced by the
desire of shareholders or the management to retain control over
the company.
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(5) Liquidity position : The payment of dividends results in cash
outflow from the company. Therefore, the management should
take into account, the availability liquid cash before taking
dividend payment decision.
(4) Determinants of Dividend Policy :
Following are the determining factors for dividend policy of the
company.
(i) Transaction costs,
(ii) Personal taxation,
(iii) Dividend clientele,
(iv) Dividend pay-out ratio,
(v) Dividend coverage ratio (PAT / Dividend paid x 100)
(vi) Dividend signalling (share price of company decreases when
dividend is paid)
(vii) Divisible profits (market price per share increases if it increases
and decreases if divisible profit decreases i.e. EPS)
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(viii) Liquidity
(ix) Rate of expansion
(x) Stability of earnings
(xi) Stability of dividends
(xii)Legal provisions
(xiii)Contractual constraints (Banks and other lenders may restraint)
(xiv)Cost of financing
(xv)Degree of control
(xvi)Capital market access
(xvii)State of the Economy
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(5) Factors for dividend payments :
The payment of dividend actually involves some legal as well as
financial consideration. The following are the important factors
which determine the dividend policy of a firm.
(i) Legal restrictions,
(ii) General state of economy,
(iii) Age of the Company,
(iv) Nature of industry,
(v) Government Policy,
(vi) State of capital market,
(vii) Past year dividend rate,
(viii)Stability of Dividends,
(ix) Taxation Policy,
(x) Liquidity Resources,
(xi) Restrictions by lenders.
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(6) Forms of Dividend Policy :
There are various dividend policies which are summarised below :
(i) Stable Dividend Policy :
The term stable dividend means when the company maintains the
same stable rate of dividend. It may be in the following forms:
(a) Constant Dividend Rate per share : It is a most popular
kind of dividend policy which advocates the payment of dividend
at a constant rate, even when earnings vary from to year. This
may be possible only when the earnings pattern of the company
does not show wide fluctuations. This policy is possible only
through the maintenance of what is called ‘dividend equalisation
reserve’. The company then invests the funds equal to such
reserves in Money Market short term investments so as to
manage the liquidity of the necessary funds in time of need. (i.e. A
specified amount will be transferred to ‘dividend equiablisation
fund or reserve every year so that the company can pay the
specified rate of dividends when the profit is less during a
particular year).
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(b) Constant Dividend Pay-out Policy :
This method is also known as ‘constant pay-out ratio method’. This
concept of stability of dividends means ‘always paying a fixed
percentage of the net earnings every year’. Under this method, if
earnings vary, the amount of dividends also varies from year to year.
In other words, the dividends varies year after year, if earnings
vary. The dividend policy is entirely based on the company’s ability
under this policy.
(ii) Regular dividend policy :
Regular dividend policy indicates that the payment of dividend at
the usual rate is known as policy of regular dividend. If a concern
follow a regular dividend policy, automatically it creates confidence
among the shareholders.
(iii) Policy to pay irregular dividend :
It implies when the company follow this policy it could not pay the
regular dividend. Because the company have uncertainty of
earnings or inadequate profit. As per this policy, if company
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earns a higher amount of profit, it could ay higher rate of
dividend. If there is no profit in any particular year, the company
does not declare dividend to its shareholders.
(iv) Policy of no immediate dividend :
A company may follow a policy of paying no dividends
immediately even when it earns huge amount of profit.
Because either its unfavourable working capital position or on
account of requirements of funds for future expansion. In
reality, this dividend policy is not adoptable.
(7) Forms of dividend :

Payment of dividend can be classified into the following forms:
(i) Cash dividend :
Dividend is paid to shareholders in the form of cash is called
cash dividend. The usual practice followed by the company is
to pay dividend in cash. It results in out-flow of funds from the
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company. Hence the firm should maintain adequate cash
resources for payment of cash dividend.
(ii) Bond dividend :
The company does not have sufficient cash reserves to pay the
dividend, it may issue bonds as against the amount due to the
shareholders by way of dividend is known as bond dividend.
Actually it is not popular in India.
(iii) Property dividend :
Property dividend are those which can be paid by the company
to its shareholders in the firm of property instead of payment of
dividend in cash. However, this type of dividend is not popular
in India.
(iv) Stock Dividend :
Payment of stock dividend is popularly known as issue of bonus
shares in India. Because in any particular year, the company
does not have an adequate cash reserves, it must decide to
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pay dividend in the form of shares. Normally, the company may
issue its own shares to the existing shareholders in lieu of cash
dividend or in addition to cash dividend.
(iv) Scrip dividend (bonus shares) :
Scrip dividend means when earnings justify a dividend is
known as scrip dividend. This is also known as ‘bonus shares’
(8) Dividend Policy Formulation :

While formulating its dividend policy, the company should
consider the following aspects :
(i) Investment decisions have the greatest impact on value
creation.
(ii) External equity is more expensive than retained earnings
because of issue costs and under-pricing.
(iii) Most promoters are adverse to the dilution of their stake in
equity and hence are reluctant to issue external equity.
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(iv) There is a limit beyond which a firm would have real difficulty
in raising debt financing.
(v) The dividend decision of the firm is an important means by
which the management conveys information about the
prospects of the company.
(9) Legal and Procedural aspects of dividends :

(i) Legal Aspects :
The amount of dividend that can be legally distributed is
governed by the Company Law, judicial pronouncements in
leading cases, and contractual restrictions. The important
provisions of company law pertaining to dividends are
mentioned below :
(a) Companies can pay only cash dividends (with the exception of
bonus shares). No dividend shall be declared or paid by a
company for any financial year except out of the profits of the
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company for that year arrived at after providing for depreciation
in accordance with the provisions of the Company’s Act or out of
the profits of the company for any previous financial year or
years arrived at after providing for depreciation in accordance
with those provisions and remaining undistributed or out of both
or out of moneys provided by the Central Government or a State
Government for the payment of dividend in pursuance of a
guarantee given by that Government.
(b) The Companies (Transfer to Reserves) Rules, 1975, provide that
before dividend declaration a percentage of profit as specified
below should be transferred to the reserves of the company.
(i) Where the dividend proposed exceed 10% but not 12.5%
of the paid-up capital, the amount to be transferred to the
reserves shall not be less than 2% of current profits.
(ii) Where the dividend proposed exceeds 12.5% but not 15%
the amount to be transferred to reserves shall not be less than
5% of the current profits.
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(iii) Where the dividend proposed exceeds 15% but not 20%,
the amount to be transferred to reserves shall not be less than
7.5% of the current profits, and
(iv) Where the dividend proposed exceeds 20%, the amount t0
be transferred to reserves shall not be less than 10% of the
current profits.
(c) Dividends cannot be declared for past years for which the
accounts have been closed.
(ii) Procedural Aspects :

The important events and dates in the dividend payment
procedures are as under :
(a) Board resolution : The dividend decision is the prerogative
of the board of directors. Hence the board of directors should
in a formal meeting resolve to pay the dividend.
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(b) Shareholders’ approval : The resolution of the board of
directors to pay the dividend has to be approved by the
shareholders in the annual general meeting.
(c) Record date: The dividend is payable to shareholders whose
names appear in the Register of Members s on the record date.
(d) Dividend Payment: Once a dividend declaration has been
made, dividend warrants must be posted within 30 days.
Within a period of 7 days, after the expiry of 30 days, unpaid
dividends must be transferred to a special account opened with
a scheduled bank.
(10) Theories of Dividend :

There are conflicting theories regarding impact of dividend
decision on the valuation of a firm / company. According to one
school of thought dividend decision does not affect the
shareholders’ wealth and so also the valuation of the company.
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While according to another school of thought, dividend decision
materially affects the shareholders’ wealth and also the valuation of
the firm. Accordingly, the dividend theories can be classified under
the following two groups :
(i)_Theory of Relevance :
(i) James Walter, (ii) Myron Gordon.
(ii) Theory of Irrelevance :

Modigliance & Miller (M & M)
(i) Theories of Relevance (Relevance concept of dividend) : Theories

which consider dividend decision to be relevant as it affects the
value of the company (firm)
(ii) Theories of Irrelevance (Irrelevance concept of dividend) :
Theories which consider the dividend to be irrelevant as it does
not affect the value of the company (firm)
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(i) Theories of Relevance (Relevance concept of dividend) :
This theory indicates that there is a relationship between firm’s
(company’s) dividend policy and the firm’s (company’s ) position in
the stock market. James Walter, Myron Gordon, John Linter,
Richardson and others are associated with the relevance concepts
of dividend. If the company declares higher rate of dividend
automatically its value increases in the stock market. Suppose it
declares low dividend rate, immediately its value decrease in the
market. This is because, the information about the rate of dividend
is immediately communicated to the investors and also the
profitability of the companies. A company must declare sufficient
dividends to meet the expectations of investors and shareholders in
order to maximise the net worth of the business. Theorists of
Dividend Relevance (Walter, Gordon, etc) consider dividend
decision to be an active variable in determining the value of a firm
(company). Dividend relevance implies that shareholders prefer
current dividends and there is direct relationship between dividend
policy and market value of a firm (company). As such, dividend
decision is therefore, relevant.
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Two models of ‘Relevance theory’ namely, (a) Walter’s model and
(b) Gordon’s model are explained below :
(a) Walter’s Model (Relevant theory): Walter’s model supports the
doctrine that dividends are relevant. The investment policy of a
firm (company) cannot be separated from its dividends policy and
both are interlinked, according to Walter. The choice of an
appropriate dividend policy affects the value of the firm
(company). This model is based on the relationship between the
company’s (i) return on investment or (internal) rate of return (r
), and (ii) cost of capital or required rate of return (k) or (ke).
According to Walter, if r > k i.e. firm (company) can earn a higher
return than what the shareholders can earn on their investments,
the firm (company) should retain the earnings. Such firms
(companies) are termed as growth firms and in their case, the
optimum dividend policy would be to plough back the entire
earnings. In their case, the dividend payment ratio (D/P Ratio)
would therefore, be zero. This would maximise the market value of
their shares.
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(b) Optimum Pay-out under Walter’s Model :
Under Walter model, for a company which earns a higher return
than the cost of capital (r > k), that is (r > ke), optimum pay-out
of dividend is Zero. That is to say, for growth firms, optimum pay-
out of dividend is zero. (refer to page-20 problem-2 , where r > ke)
(c) Assumptions of Walter’s model :

Following are the assumptions of Walter’s Model :
(i) No External Financing : Only Retained earnings are used to finance
all investments and no new debt or equity is raised.
(ii) Constant Internal Rate of Return (r ) : Internal Rate of Return of
the firm is constant. Constant Cost of Equity Capital (ke) : Cost of
equity capital or Equity capitalisation rate (ke) of the firm is
constant.
(iii) Constant EPS : Value of EPS is assumed to remain constant.
(iv) Constant DPS : Value of DPS (i.e. Dividend per share) is assumed
to remain constant forever.
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(v) 100% pay-out or Retention: All earnings are either distributed as
dividend or reinvested internally immediately.
(vi) Infinite Life: The organisation is assumed to have infinite life (long
life).
(d) Criticism of Walter’s model :
Walter’s model or approach has been criticised on the following
grounds :
(i) (Internal) Rate of Return remain constant is not true, because the
rate of return changes with increase or decrease in investments.
(ii) This model assumes that the cost of capital (ke) remain constant.
Actually, the cost of capital also changes because of a firm’s
(company’s) risk pattern also changes and it does not remain
constant.
(iii) The basic assumptions of the Walter’s model is that all the
investments are financed only through retained earnings / internal
rate of return (r). This assumptions is not real. Actually, firms
(companies) raises funds not only from the retained earnings but
also through equity and new debt also.
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(e) Implications of Walter’s Model :
(i) The optimum dividend policy of a firm / company is determined by
the relationship between the rate of return on firms’ investments or
internal rate of return (r) cost of capital (ke).
(ii) If the firm can earn higher internal rate of return (r) than the cost
of capital (r > ke) , it can retain the earnings. These firms are called
as ‘growth firms’ and their dividend policy could be to plough back
the earnings. The optimal pay-out ratio for a growth firm can be
zero. If the rate of return on investments or internal rate of return
(r) exceeds the cost of capital (ke), the price per share increases as
the dividend payout ratio decreases.
(iii) If the cost of capital is more than the firm’s IRR (r < ke) the
optimum dividend policy would be to distribute the entire earnings
as dividend. Optimum pay-out ratio of such firms would be 100%.
(iv) If IRR of the firm is equal to its cost of capital (r = k), it does not
matter whether the firm retains or distributes its earnings. Optimal
pay-out ratio for such firms is irrelevant.
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Walter’s Model (Relevant theory): James Walter has suggested
the following formula for determining the market value of a share :
Formula : P = [D + (r / Ke) x (E – D) ] / (ke /100)
P = Market price per equity share (MPS)

D = Dividend paid per share,
r = Rate of Return
E = Earning per share (EPS)
Ke = Cost of equity capital (or) equity capitalisation rate.
(Note : Rate of return (r) = (Distributable profit to equity
shareholders / Total amount of equity shares) x 100
Optimum Pay-out under Walter’s Model :
Under Walter model, for a company which earns higher rate of
return than the cost of capital (r > k) optimum pay-out is Zero.
That is, for growth firms, optimum pay-out is zero. That is the entire
earnings (100%) are retained in the business. (This is possible
only in theory. No company will retain the entire profits).
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Dividend Payment Formulae (Ratios) :
Distributable profit to eq. shareholders
(i) Rate of Return (r )= ------------------------------------------------ x 100
Total amount of equity shares
Distributable profit to eq. shareholders

(ii) Earning per share (EPS) = -----------------------------------------------
Total No. of equity shares
Total amount of dividend paid

(iii) Dividend paid (D) per share = ------------------------------------------
Total No. of equity shares
Dividend paid per share

(iv) Dividend Pay-out Ratio (D/P) = ----------------------------- x 100
EPS
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(v) Dividend paid (D) = EPS x (Dividend Pay out Ratio / 100)
Market price per share (MPS)

(vi) Price-Earning Ratio (P/E Ratio) = -------------------------------
EPS
(vii) Market Price per share = EPS x PE Ratio
Earnings per share EPS

(viii)Cost of Capital(ke) = ------------------------- x 100 = ------ x 100
Market price of share MPS
(ix) Cost of Capital = (1 / PE Ratio) x 100
(x) Dividend Pay-out = EPS (1 – Retention % of Profit)

(xi) Retention of Profit = EPS ( 1 – Dividend pay-out %)
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(xii)Cost of Capital (COC) = [(Div. paid / Market Price of eq.share) x
100 ] + (Growth rate/100)
Cross multiplication =
MP x COC = (Dividend Paid x 100) + (Growth rate / 100)
Market Price of Eq. share (MPS) = (Dividend paid / (COC – GR)
(xiii) Market Value of the Company = MPS x No. of equity shares
Example :
Total earnings (distributable profit) = Rs 100 lakhs
Dividend paid = 30% = 100 x (30 / 100) = Rs 30 lakhs
Retained earnings = (1 – D) = (1 – 30%) = 70%
No. of equity shares = 1,00,000
Dividend paid = (Total Amount of dividend / No. of Eq. shares)

= 30 lakhs / 1 lakhs shares = Rs 3 per share
Dividend paid per share = Rs 3
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Students should note these relevant points : (important)
(i) When Earnings per share (EPS) increases Market Price per share
(MPS or P) increases.
(ii) When dividend pay-out 100%, ‘Retained earnings’ is ‘zero’.
(iii) When ‘Retained earnings’ is 100%, dividend pay-out is ‘zero’.
(iv) When dividend pay-out percentage changes, Market Price per
share (MPS or P) changes (see problem-1 on page – 35 herein)
(v) When the dividend pay-out increases, Market Price per Share
(MPS) decreases (comes down).
(vi) When the retained earnings (amount) increase, Market Price of per
share (MPS) increases (goes up).
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Students should remember the following points before solving
the problems :
(i) Where Rate of Return is more than equity capitalisation rate (ke),
optimum dividend pay-out is zero. That is entire earnings are
retained in business. For growth companies, optimum pay-out of
dividend is zero.
(ii) Higher dividend pay-out ratio will result in reduction in the Market
Price of share (MPS).
(iii) Relevance Theory of Dividend was advocated by :
(1) James Walter, and (2) Myron Gordon.
(iv) Irrelevance Theory of Dividend was advocated by:
Modigliani and Miller (M & M)
(v) If the dividend pay out is 40% retained earnings is 1– 40% = 60%
(If retained earning is given in the problem, dividend payout
should be calculated by the students, to solve the problem,
because ‘D’ (dividend paid) is to be taken in the formula).
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(vi) If the dividend pay out ratio increases, the market price of equity
share will come down. And if the retained earnings increases (as
compared to dividend paid), the market price of share will increase
(when retained earnings increases, payment of dividend comes
down).
(vii) Price of single equity share is Market Price(P) or (MPS) and total
value of all shares put together is known as Market value of the
Company (MV).
(viii)If retention of profit (%) is given in the problem, you should
calculate dividend paid (D). For this, formula is :
Dividend Pay-out = EPS(1 – Retention % of profit).
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For problem No.1 (page-34) students should follow steps given below:
(important)
(1) First, write formula,

(2) Write each variable in the formula in serial order,
(3) Write the figures given in the problem against each variable,
(4) Open working notes (separately) and calculate those variables in
the formula, which are not given in the problem.
(5) Substitute, the calculated value (from working notes) in the
formula and calculate the answer.
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Formula (Walter model) :
P = [D + (r / ke) x (E – D)] / (ke / 100)
Explanation:
(i) D (Dividend paid per share) = 6 x (30 / 100) = Rs 1.80
(ii) r (Rate of Return) (given) = 20% ( 20/100) = 0.20
(iii) Ke (Cost of Equity Capital) (given) = 10% (0.10)
(iv) E or (EPS) (Earnings per share) = Rs 6 (given)
(v) Now substitute these figures in the formula and calculate P or MPS
(Market Price per share)
(see next slide for answer)
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Dividend Policy
(Walter Model)
Problem - 1
SPN Company Ltd earns Rs 6 per share having
capitalisation rate of 10% and has a return on
investment at 20%. According to Walter's Model

what should be the price per share at 30% dividend
pay-out ratio. Write
comments.
Solution to Problem-1 :
Walter Model : Formula :
P = [ D (+) (r / Ke) x (E - D) ] / (Ke / 100)
Dividend = D = 6 x (30/100) = 1.80

Internal rate of return = r = 20% or 0.20
Cost of capital = Ke = 10% or 0.10
Earning per share = E = 6
Market Value of share = P =

P = [ 1.80 (+) (0.20 / 0.10) x (6 - 1.80) ] / 0.10
P = [1.80 (+) (2.0 x 4.20)] / 0.10
P = [1.80 + 8.40] / 0.10
P = 10.20 / 0.10 = 102

Market Value of share = Rs 102
Comments: : As per the calculation of

Walter Model, the MPS is Rs 102.
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Problem-2 :
MCM Ltd earnings are Rs 5 per share. Capitalisation
rate is 10% and return on investment is 12% and
No. of equity shares are 1,00,000.
Under Walter model determine :
(i) Market price of share at zero pay-out of dividend.
(ii) Market price of share if payout of dividend is 20%
(iii) Market price of share if payment of dividend is 40%
(iv) Find the value of company
(v) Write comments
Solution to problem -2 :
P = [D + (r / ke) x (E - D) ] /
(ke / 100)
(i) Market price per share if pay-out is zero :

Dividend per share = D = 0
Rate of Return = r = 12% or 0.12
Earnings per share = E = Rs 5
Market price per share = P =

P = [ 0 (+) (0.12 / 0.10) x (5 - 0) ] / 0.10
P = [ 0 (+) (1.20 x 5)] / 0.10
P = [ 0 + 6 ] / 0.10
P = 6 / 0.10 = 60
Market Price of share (MPS) =
Rs 60
Market Value of Company =
MPS x No. of equity shares =
60 x 1,00,000 = Rs 60 lakhs
Comments : r = 12.5% and ke =

10%. As per rule, if r > ke, it is a
growth company.
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(ii) Market price per share if dividend payment is 20%
Dividend per share = D = 20% of Rs 5 = Re 1

P = [ 1 (+) (0.12 / 0.10) x (5 - 1) ] / 0.10
P = [ 1 (+) (1.20 x 4)] / 0.10
P = [ 1 + 4.80 ] / 0.10
P = 5.80 / 0.10 = 58
Market Price of share (MPS) =
Rs 58
Market Valuation of Co =
58 x 1,00,000 = Rs 58 lakhs
Comments : As per Walter’s

theory, if dividend payout
increases, Market Price of Share
(MPS) decreases and also
Market Valuation of the
Company decreases. It is
proved correct above.
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(iii) Market price per share if dividend payment is 40%
Dividend per share = D = 40% of Rs 5 = Re 2

P = [ 2 (+) (0.12 / 0.10) x (5 - 2) ] / 0.10
P = [ 2 (+) (1.20 x 3)] / 0.10
P = [ 2 + 3.60 ] / 0.10
P = 5.60 / 0.10 = 56
Market Price of share (EPS)
= Rs 56
Comments: Higher dividend

pay-out will result in reduction
of MPS and also valuation will
come down.
It is proved in this problem :

(i) Div. paid is 20% MPS is
\Rs 58, and
(ii) Div. paid is 40% MPS has
come down further to Rs 56
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Problem - 3
The earnings per share of PMT Ltd is Rs 20. Rate of
equity capitaisation rate is 12% and rate of return on
investments is 15%. Compute the market price of
share
using Walter's model if dividend pay-out is
(i) 20%, (ii) 60% and (iii) 100%.
Write comments.
Solution to problem - 3 :
P = [D + (r / Ke) x (E - D)] / (Ke
/ 100)
(i) Market price per share if pay-out is 20% :

Dividend per share = D =
20%
Earnings per share = E = 20% of 20 = Rs 4
Market price per share(MPS) =

P = [ 4 (+) (0.15 / 0.12) x (20 - 4) ] / 0.12
P = [ 4 (+) (1.25 x 16)] / 0.12
P = [ 4 + 20 ] / 0.12
P = 24 / 0.12 = Rs 200
Market Price of share = Rs 200
39
(ii) Market price per share if pay-out is 60% :
Dividend per share = D = 60%
Rate of Return = r = 15% or 0,15
Earnings per share = E = 60% of 20 =
(20 x (60/100) = Rs 12

P = [ 12 (+) (0.15 / 0.12) x (20 - 12) ] / 0.12
P = [ 12 (+) (1.25 x 8)] / 0.12
P = [ 12 + 10 ] / 0.12
P = 22 / 0.12 = 150
Market Price of share = Rs 183.33
40
(iii) Market price per share if pay-out is 100% :
Dividend per share = D = 100%
Earnings per share = E = 100% of 20 = Rs 20

P = [ 20 (+) (0.15 / 0.12) x (20 - 20) ] / 0.12
P = [ 20 (+) (1.25 x 0)] / 0.12
P = [ 20 + 0 ] / 0.12
P = 20 / 0.12 = 166.67
Market Price of share = Rs 166.67
Comments :
41
Problem - 4 :
(Walter’s Model)
The cost of capital and rate of return on investment of
MRM Ltd are 10% and 15% respectively. The Company has
10,00,000 equity shares of Rs 10 each outstanding and
earnings per share is Rs 5. Calculate the value of the firm
in the following situations. Use Walter's model and comment
on the results. (i) 100% retention of earnings,

(ii) 50% retention, (iii) No retention.
(iv) Write comments
Remember ::
(i) If 100% retention, it means dividend
pay-out is zero;
(ii) 50% retention means, 50% dividend
paid;
(iii) No retention means, 100%
dividend paid.
Accordingly calculate.
42
Walter Model :
Formula :
P = [ D + (r / Ke) x (E - D)] / (Ke
/ 100)
(i) Market price per share at 100% rention of profits :

that is , pay-out of dividend is zero (100% - 100%)
Dividend per share = D = 0

P = [ 0 (+) (0.15 / 0.10) x (5 - 0) ] / 0.10
P = [ 0 (+) (1.50 x 5)] / 0.10
P = [ 0 + 7.50 ] / 0.10
P = 7.5 / 0.10 = 75
Market Price of share (MP) =
Rs 75
Value of company = Rs 75 x 10,00,000 =
Rs 7,50,00,000
Note : If 100% of profit is retained, dividend pay-out is

zero
43
(ii) Market price per share at 50% retention of profits :
that is , pay-out of dividend is 50% (100% - 50%)
Dividend per share = D = 50% of EPS =
D = 50% of Rs 5 = Rs 2.50

P = [ 2.50 (+) (0.15 / 0.10) x (5 - 2.50) ] / 0.10
P = [ 2.50 (+) (1.50 x 2.50)] / 0.10
P = [ 2.50 + 3.75 ] / 0.10
P = 6.25 / 0.10 = 62.50

Market Price of share (MP) = Rs 62.50
Market Value of
company (MV) =
62.50 x 10,00,000 = Rs 6,25,00,000 =
Rs 625 lakhs (or ) Rs 6.25 cr.
44
(iii) Market price per share at no retention of profits :
that is , pay-out of dividend is 100%
Dividend per share = D = 100% of EPS =
D = 100% of Rs 5 = Rs 5
Market price per share(MP) = P

P = [ 5 (+) (0.15 / 0.10) x (5 - 5) ] / 0.10
P = [ 5 (+) (1.50 x 0 )] / 0.10
P = [ 5 + 0 ] / 0.10
P = 5 / 0.10 = 50
Market Value of share = Rs 50
Value of the firm =
50 x 10,00,000 = Rs 5,00,00,000
Note : The firm is a growth firm (r > Ke). As pay-out of

dividend increases, value of firm decreases. Hence
ideal pay-out of dividend is Zero percent in this case
Comments :
45
Problem-5 :
A Ltd was started a year ago with a paid up equity
capital of Rs 20,00,000. The other details are as follows:
Earning of the Company : Rs 2,00,000
Dividend paid : Rs 1,60,000
Price-Earning Ratio : 12.5 times
Number of eq. shares : 2,00,000
Find out whether the company's dividend pay-out
ratio is optimal using Walter's model.
Write Comments.
46
(a) Earning per share (EPS) = Earnings / No. of
shares
EPS = 2,00,000 / 2,00,000 = Re 1
(b) Dividend per Share (DPS) =

Dividend paid / No. of shares =
1,60,000 / 2,00,000 = Re 0.80
(c ) Internal Rate of Return ( r ) =

Total earnings / Amount of eq. shares =
(2,00,000 / 20,00,000) x 100 = 10%
(d) Cost of Capital = 1 / PE Ratio =

( 1 / 12.5) x 100 = 8%
(e) Computation of Market Price of share =

P = [ D + (r / ke) x (E - D) ] / ke
P = [ 0.80 + (0.10 / 0.08) x ( 1 - 0.80) ] / 0.08
P = [ 0.80 + 0.25] / 0.08 = 1.05 / 0.08 = 13.125
= Rs 13.13
(f) Dividend pay-out =
(1,60,000 / 2,00,000) x 100 = 80%
Comments : Using Walter's model, company's ratio at

80%
is not optimal. The price of share would be maximum
if the dividend pay-out ratio is zero.
47
Problem-6 (Homework problems)
The earnings per share of B Ltd is Rs 4 and the rate of
capitalisation applicable is 10%. The company has on hand, an
option of adopting (i) 50% (ii) 75% and (iii) 100%. Dividend
payout ratio, compute the market price of company’s shares as per
Walter’s model if it can earn a return of 10% on its retained
earnings. Write co mments.
Problem-7 (H.W)
Following are details regarding the companies X Ltd, Y Ltd, and Z Ltd.
(i) X Ltd : r = 15%, ke = 10%, E = Rs 8
(ii) Y Ltd : r = 5%, ke = 10%, E = Rs 8
(iii) Z Ltd : r = 10%, ke = 10%, E = Rs 8
Calculate the value of equity share of each of the company applying
Walter’s model; when dividend payout ratio is (a) 50%, (b) 75%
and (c ) 25%. You are required to offer your comments on the
results. Write comments.
48
Problem-8 (H.W)
ABC Company Limited is expecting 10% return on total assets of
Rs 50 lakhs. The company has outstanding shares 20,000. The
directors of the company have decided to pay 40% of earning as
dividends. The rate of return required by shareholders is 12.5%.
Rate of return expected on investment is 5%. You are required to
determine the price of the shares using Walter’s model. Write
comments.
Problem-9 (HW) (case of normal firm) :

The earnings per share of a company are Rs 10. The equity
capitalisation rate is 10%. Internal rate of return on retained
earnings is 10%. Using Walter’s formula :
(a) What should be the optimum pay-out ratio of the company ?
(b) What should be the price of share at optimum payout ratio ?
(c ) Shall this price be affected if different payout (say 80%) were
employed ? (d) Write comments.
49
Problem – 10 (H.W) (case of growing firm) :
capitalisation rate is 10%. Internal Rate of Return on retained
(a) What should be the optimum payout ratio of the company ?
(c ) How shall this price be affected if different payout (80%) were
employed by the company ? (d) Write comments.
Problem – 11 (H.W) (case of declining firm) :

capitalisation rate is 20%. Internal rate of return on retained
(a) What should be the optimum payout ratio of the company ?
(b) What should be price of share at optimum payout ratio ?
(c ) Shall this price be affected if different payout (say 80%) were
employed ? (d) Write comments.
50
(b) Gordon Growth Model : (Relevant Theory)
According to Myron Gordon, dividend policy almost always
affects the value of the firm. He had stated that market price
of a share of the company is equal to present value of infinite
stream of dividend. Gordon’s model explicitly relates to the
market value of the firm to dividend policy. Dividends of most
companies are expected to grow and evaluation of value-shares
based on dividend growth is often used in valuation of shares.
Dividend valuation model assumes a constant level of growth
in dividends in perpetuity. This is a theoretical model used to
value ordinary equity shares. The model incorporates the
retention of earnings and growth of dividends and hence it is
also called as ‘Dividend Growth Valuation Model’. The main
proposition of the model is that the value of a share reflects the
value of the future dividends accruing to that share. Hence,
the dividend payments and its growth are relevant in valuation
of shares. The model holds that share’s market price is equal to
the sum of share’s discounted future dividend payments.
51
Gordon Model considers both of the following :
(i) Dividend payment (or Retention of earnings), and
(ii) growth of dividend in future (g)
Assumptions of Gordon Model :

Gordon growth valuation model using dividend capitalisation is
based on the following assumptions :
(i) No external Financing : Only Retained earnings are used to
finance all investments and no new debt or equity is raised.
(ii) Constant Internal Rate of Return (r) : The Internal Rate of Return
(r ) of the firm is constant and is taken as the appropriate discount
rate.
(iii) Constant Cost of Capital (k) : Cost of Capital (k) of the firm is
constant.
(iv) Constant Retention Ratio (b) : Retention Ratio (b) of the firm
once decided upon is constant.
(v) Constant Growth (g) : Growth rate (g) of the firm is constant
forever.
52
(vi) Cost of Capital greater than Growth Rate : Firm’s Cost of Capital
(k) is assumed to be greater than growth rate (g) in order to
derive meaningful market value of share.
(vii) All equity firm : The firm is using only equity and not debt.
(viii)No taxes : No corporate taxes exist.
(ix) Infinite earnings : The organisation is assumed to have infinite
earnings.
(x) Infinite Life : The organisation is assumed to have infinite/
perpetual life.
53
Gordon’s Dividend Formula : (Relevant theory)
In valuation of share under Gordon Growth Model, the following

formula is used :
D0 ( 1 + g) D1
(1) Formula-1 : P0 = ------------------- (or) ---------------
Ke – g Ke – g
Explanation:
P0 (P zero) = Current market price of equity share
D0 (D zero) = Current year’s dividend
D1 (one) = Expected dividend next year
Ke = Cost of equity capital
g = Expected future growth rate of dividends.
Note : If the current dividend (D0) and growth rate are given, the
above formula should be applied.
54
Gordon’s Formula : (Relevant theory)
Shareholder’s required rate of return (cost of capital (ke) can also
be calculated by using the Capital Asset Price Model (CAPM). The
model required the estimation of the future growth of dividends.
E1 ( 1 - b) E1 (1 – b)
(2) Formula-2 : P0 (zero) = ---------------- (or) ----------------
Ke – br ke – g
Explanation:
P0 (zero) = Current ex-dividend market price of equity share
E1 = Expected earnings per share (EPS)
b = Retention Ratio
(1 – b) = Dividend payout Ratio
Ke = Cost of equity capital or capitalisation rate (i.e. expected rate
of return of equity capital)
br= g = (b x r)= Expected future growth rate of earnings (r), retention
of profit (b)
Note: If the expected earnings, retention ratio of dividend, growth rate
are given, then the above formula should be applied.
55
Students should remember : (Gordon dividend formulas)
(i) P0 (zero) = D0 (1 + g) / (ke – g) (or) D1 / (ke –g )
(Note : P0 (zero) is current Market Price, D0 (zero) is current year’s
dividend.
D1 is next year dividend. G is growth in dividend for next year over
current year. Hence D0 (1 + g) = D1)
(ii) Ke = [D0 ( 1 + g) / P0] + g

(Note : This formula is derived from formula-1 above)
(iii) P0(zero) = [E1 (1 – b) / ke – br] (or) [E1 (1 – b) / (ke – g)

(Note : This formula is based on Capital Assets Pricing Method (CAPM)
(iv) Gordon Model is based on two factors namely, (1) Retention of

earnings, (2) Growth of dividend in future.
(v) The growth of earnings will increase the valuation of the shares.
56
(vi) Higher amount of retention of profit will increase the share price
in the market (MP) and higher amount of pay-out of dividend will
reduce the share price in the market.
(vii) If current dividend and growth rate in dividend are given in the
problem, students should apply the following formula.
P0 (P zero) = [D0 x (1 + g)] / (ke –g)
(viii) If the Expected earnings, Retention ratio of dividend, growth rate

are given, then apply the following formula :
P0 = [E1 x (1 – b)] /(kg – g) (or) [E1 x (1 – b)] / (ke – br)
57
Example :
PAT = Rs 100 cr.
Retained earnings = Rs 60 cr.
Dividend pay-out = 1 – 60 = Rs 40 cr.
Dividend pay out ratio is same next year. (40 / 100) x 100 = 40%
Increase in PAT to Rs 200 cr.

Retained earnings = Rs 120 cr.
Dividend pay-out = Rs 80 cr. (80 / 200) x 100 = 40%
Note : No. of shares remaining constant, there is growth in dividend

pay-out from Rs 40 cr. To Rs 80 cr.
58
Dividend Policy - Gordon Model
Problem-1 :
X Ltd has an investment of Rs 5,00,000 in assets and
Rs 50,000 shares outstanding at Rs 10 each. It earns
a rate of 15% on its investment and has a policy of
retaining 50% of the earnings. If the cost of equity share is
10%, determine the price of company's share using
Gordon's Growth Model. What will be share price if the
company has a payout of 80% or 40% ?
Write comments.
59
Solution to problem-1 :
Gordon's share valuation model : Formula :
EPS = PAT / No. of eq.shares
P0 = E1 (1-b) / (ke - br)
EPS = 500,000 x 0.15 / 50,000 = 1.50

(E1 = 1.50, b = 0.50, r = 15%, ke = 10%,
br = 0.50 x 0.15) Now apply in the formula :
(1) If dividend pay out is 50% :

P0 = 1.50 x (1 - 0.5) ] / 0.10 - (0.50 x 0.15) =
0.75 / 0.025 = Rs 30
(2) If dividend payout is 80% :

P0 = 1.5 x (1 - 0.20] / 0.10 - (0.20 x 0.15) =
1.20 / 0.07 = Rs 17.14
(3) If dividend payout is 40%

P0 = 1.5 x (1 - 0.6) ] / 0.10 - (0.60 x 0.15) =
= 0.60 / 0.01 = Rs 60
Comments :
60
Problem-2 :
The shares of C Ltd are selling at Rs 40 per share. The firm
had paid dividend of Rs 2 per share. The current growth
of dividend of the company is 5% per year.

You are required to
determine : (i) cost of capital of the company,
(ii) Estimated market price of the share, if the anticipated
growth rate of the company raises to 8%

(iii) Write comments.
Note :
(i) Gordon Formula =
P0 = D0 ( 1 + g) / (ke – g)
(ii) Derived formula for ke :

P0 = D0 ( 1 + g) =
P0 (ke – g) = D0 ( 1 + g) =
ke – g = D0 ( 1 + g ) / P0 =
ke = [D0(1 + g) / P0 ] + g
Note : This formula is to be applied in this

problem.
61
Solution - 2 :
(i) Determination of Cost of Equity Capital :
ke = [ D0 (1 + g) / P0 ] + g =
[ 2 ( 1 + 0.05) / 40 ] + (5/100) =
(2.10 / 40 ) + 0.05 =
(2.10 / 40) + 0.05 =
0.0525 + 0.0500 = 0.1025 =

0.1025 x 100 = 10.25%
Ke = 10.25%
(ii) Market Price of share :

P0 = D0 (1 + g) / (ke – g)
= 2 ( 1 + ( 5/100)1.08 ) /
(10.25 /100) – (5.00 /100) =
= (2 x 105) / (10.25 – 5.00) =
= 210 / 5.25 = 40
P0 = Rs 40
MPS = Rs 40
Comments :
62
Problem - 3 :
Ruchi Soya Limited is an established company having

its shares quoted in the stock market. The company has
distributed dividend at 20% p.a. The paid up capital of the
company was Rs 50 lakhs shares of Rs 10 each. Annual
growth rate in dividend is expected at 3%. The expected
rate of return on its equity capital is 15%. Calculate the
value of shares of the company under Gordon's dividend
growth model.
Write comments.
Solution – 3 :
Working Notes :
Paid up capital = Rs
50 lakhs
FV of share = Rs 10
lakhs
No. of equity
shares = 50 / 10 = 5
lakhs
63
Solution – 3
Working Notes :
50,00,000 x 20% =
10,00,000 =
= 10,00,000 / No. of
equity shares =
= 10,00,000 /
5,00,000 = Rs 2
Dividend paid Rs 2
MPS = P0 =
D0 ( 1 + g) / (ke - g)
= 2(1 + 0.03) /
(0.15 – 0.03) =
= 2.06 / 0.12 = Rs
17.17
MPS = Rs 17.17
Market Value of Co
= MPS x No. of sh.
= 17.17 x 5,00,000=
= Rs 85,85,000
64
Problem - 4 :
Gordon's Model (case of normal firm) :
Earnings per share of a company are Rs 10. Equity

Capitalisation Rate is 10%. Internal Rate of Return on
Retained Earnings is 10%. Using Gordon's formula :
(a) What should be optimum payout ratio of the company ?
(b) What should be price of share at optimum payout ratio?
(c ) Shall this price be affected if dividend payout of 80% was
ploughed back into the company ?
Write comments.
65
(a) Since ( r) (i.e. rate of return on retained earnings) = ke
(i.e. equity capitalisation rate), it is the case of normal
com pany. Hence any payout ratio will be optimum
payout ratio.
(b) & (c ) Price of share at payout ratio of 10% and 80% as
per Gordon's formula :
P0 = E (1 - b) / (ke - br)
Particulars 10% pay out 80% payout

ratio ratio
E = Earnings per share Rs 10 Rs 10
b = Retention Ratio 0.90 0.20
1 - b = Dividend pay out ratio 0.10 0.80
D = E(1 - b) Dividend per share Re 1.00 Rs 8.00
r = Internal Rate of Return on 0.10 0.10
Retained Earnings
ke = Equity capitalisation rate 0.10 0.10
g = br = Grow th Rate (b x r) 0.09 0.02
P0 = Market Price =
E ( 1 - b) / (ke - br) =
10 ( 1 - 0.90) / (0.10 - 0.09) = Rs 100
10 ( 1 - 0.20 ) / (0.10 - 0.02) = Rs 100
Hence, the price will remain the same even if different payout is
em ployed. Thus, in case of normal firm, the price w ill remain
the same at every payout ratio.
66
Problem - 5 :
Gordon's model (case of growing firm) :
Earnings per share of a company are Rs 10. The equity
capitalisation rate is 10%. Internal Rae of Return on Retained
Earnings is 20%. Using Gordon's formula :
(b) What should be price of share at optimum payout ratio ?
(c ) Shall this price be affected if different payment,
(say 55% or 80%) were employed ? Write
comments.
67
Solution to Problem - 5 :
(a) Since ( r) (i.e. Rate of Return on Retained Earnings) is
greater than ( > ) ke (i.e. Equity Capitalisation Rate), it is the
case of growing company. Hence, optimum payout ratio for the
company will be 0%.
(b) and (c ) : Price of share at payout ratio of 0%, 55% and 80%
as per Gordon's formula :
Particulars 0% payout 55% payout 80% payout

ratio ratio ratio
E = Earnings per share Rs 10 Rs 10 Rs 10
b = Retention Ratio 1.00 0.45 0.20
1 - b = Dividend pay out ratio 0.00 0.55 0.80
D = E(1 - b) Dividend per share 0.00 Rs 5.50 Rs 8.00
r = Internal Rate of Return on 0.20 0.20 0.20
Retained Earnings
ke = Equity capitalisation rate 0.10 0.10 0.10
g = br = Growth Rate 0.20 0.09 0.04
P0 = Market Price =
E ( 1 - b) / (ke - br) =
10 ( 1 - 1) / (0.10 - 0.20) = 0
10 ( 1 - 0.45) / (0.10 - 0.09) = Rs 550
10 ( 1 - 0.20) / (0.10 - 0.04) = Rs 133.33
Hence the price will decrease if the payout ratio different from optimum payout
ratio is employed
Comments : If the internal rate

of return ® is more than equity
capitalisation rate (ke), there is
no dividend pay-out (zero).
Entire earnings are retained in
the company.
68
Problem - 6 (case of declining firm)
Earnings per share of a company are Rs 10. Equity
Capitalisation
Rate is 20%. Internal Rate of Return on Retained Earnings is
10%.
Using Gordon's formula :
(c ) Shall this price be affected if different payout (say 80%)
wee employed ?
(d) Write comments.
69
(a ) Since (r ) (i.e. Rate of Return on Retained Earnings )
less than ( < ) (i.e. Equity Capitalisation Rate), it is the case of
declining company. Hence optimum payout ratio for the
company will be 100%.
Gordon's formula =
P0 = D / (ke - g) (or) E ( 1 - b) / (ke - br)
Particulars 100% payout 80% payout

ratio ratio
E = Ernings per share Rs 10 Rs 10
b = Retention Ratio 0.00 0.20
1 - b = Dividend pay out ratio 1.00 0.80
D = E(1 - b) Dividdend per shareRs 10 (1 - 0) = Rs 10 (1 - 0.20)
Rs 10 = Rs 8
r = Internal Rate of Return on 0.10 0.10
Retained Earnings (10 / 100)
ke = Equity capitalisation rate 0.20 0.20
g = br = Growth Rate 0 0.02
P0 = Market Price =
E ( 1 - b) / (ke - br) =
10 ( 1 - 0) / ( 0.20 - 0 ) = Rs 50
10 ( 1 - 0.20 ) / 0.20 - 0.02) = Rs 44.44
Hence, the price will decrease if a payout ratio different from

optimum payout ratio is employed. Thus, in case of declining
firm the price decreases as the payout ratio decreases.
70
Problem – 7 (homework)
The following data is available for Vidyut Plastics Ltd.
Earnings per share = Rs 8
Rate of return on investment (IRR) = 18%
Rate of return required by shareholders : 15%
If the Gordon valuation model holds, what will be price per share,
when the dividend payment ratio is (i) 25% and (ii) 50%.
Write comments.
Problem - 8 (homework)
The following data are available of a Swananda Co. Ltd
Earnings per share : Rs 10
Rate of return on investment (IRR) : 20%
Rate of return required by shareholders : 16%
Required : PTO
71
(a) If Gordon valuation model holds, what will be the price per
share, when the dividend payout ratio is (i) 25% and (ii) 50%
(b) What will be price per share as per the Walter’s model if the
payout is (i) 40%, (ii) 50% and (iii) 60%.
(c ) Write comments.
Problem – 9 (homework) :
Royal Products Ltd is an established company having its shares
quoted in the major stock exchanges. Its share current market
price after dividend distributed at the rate of 21% p.a. having a
paid up share capital of Rs 50 lakhs of Rs 10 each. Annual
growth rate in dividend expected is 3%. The expected rate of
return on its equity capital is 16%. Calculate the value of the
company, based on Gordon’s dividend growth model. Write
comments.
72
Problem-10 (home work) :
The shares of a chemical company are selling at Rs 20 per share.
The firm had paid dividend at Rs 2 per share last year. The
estimated growth of the company is approximately 5% per
year. (i) Determine the cost of equity capital of the company,
(ii) Determine the estimated market price of the equity share if
the anticipated growth rate of the firm (a) rises to 8% and (b)
fall to 3%. Write comments.
73
(ii) Modigliani and Miller Theory (M-M Dividend Theory)
(a) Theory of Irrelevance (Irrelevance Concept of Dividend):
According to Modigliani and Miller (M – M), under a perfect market
situation, the dividend policy of a company (firm) is irrelevant as it
does not affect the market price (MPS) market value of the
company(firm). They argue that the value of the firm depends on
the company’s earnings. Company’s earnings are influenced by its
investment policy and not by the dividend policy. Hence, M-M
advocated that dividend payment is irrelevant in the valuation of
the company and Market Price per share (MPS).
M-M Theory states that :

Value of firm(i.e. wealth of shareholders)--→ (depends on) --→
Firm’s earnings ---→ (depends on) -----→
Firm’s investment policy and not dividend policy
74
Thus, when the investment policy of the firm is given, the
dividend decision (i.e. the decision of earnings between
dividend and retained earnings) is not of any significance in
determining the value of the firm.
MM Dividend Theory also known as “Irrelevance Concept of

Dividend” advocates that the dividend policy has no effect on
the share prices of a company and is therefore, of no
consequence. It states that the investors do not differentiate
between dividends and capital gains. Their basic desire is to
earn higher return on their investment. In case the company
has adequate investment opportunities giving a higher rate of
return than the cost of retained earnings, the investors would
be content with the firm retaining the earnings. However, if
the expected return on projects is likely to be less than what
it would cost, the investors would prefer to receive the earnings
(i.e. dividends). Thus, a dividend decision is essentially a
75
financing decision, i.e. whether to finance the company’s funds
requirements by retained earnings or not. In case the
company has profitable investment opportunities, it will retain
the earnings to finance them, otherwise distribute them. The
shareholders are only interested in income whether it is in the
form of dividend or in capital gains (means appreciation in the
value of shares of the company in the share market).
In essence, M-M approach states that the price of shares of a

firm is determined by its earning potentiality and investment
policy and not by the pattern of income distribution. As
observed by them, “under conditions of perfect capital
markets, rational investors, absence of tax discrimination
between dividend income and capital appreciation, given the
firm’s investment policy, its dividend policy may have no
influence on the market price of shares”. The logic put
forward by ‘M-M hypothesis’ is that whatever increase in the
76
wealth results from dividend payment, will be exactly off-set by
the effect of raising additional capital. For example, if a
company having investment opportunities, distributes all its
earnings among shareholders, it will have to raise the capital
required from outside. This will result in increasing the number
of shares, resulting in fall in the future earnings per share.
Thus, whatever a shareholder has gained as a result of
increased dividends will be neutralised completely on account
of fall in the value of shares due to decline in the expected
earning per share.
(b) Assumptions of M-M Theory :

M-M theory (known as irrelevance concept of dividend theory)
is based on the following assumptions :
(i) Perfect Capital Market :
Capital markets are perfect which means that - (pto)
77
(1) Investors are free to buy and sell securities,
(2) Investors behave rationally,
(3) There are no flotation costs (issue management cost) and
transaction costs,
(4) Market information is freely available to the investors,
(5) Investors are well informed about the risk-return on all types
of securities.
(6) No investor is large enough to affect the market price of a
share.
(ii) No taxes : There are no taxes or there is no difference in the rate
of tax applicable to dividend income and capital gains.
(iii) Fixed Investment Policy : The organisation has a fixed investment
policy.
(iv) No Risk : Risk and uncertainty do not exist. In other words,
investors are able to forecast future prices, profits and dividends
with certainty.
78
(c ) Criticisms of M-M Model :
The assumptions of M-M theory constitute its deficiencies :
(1) No perfect Capital Market : There is no perfect capital market.
In fact, capital market is imperfect.
(2) Existence of Transaction Costs : Transaction costs exist in the
capital market (brokerage, fee, etc).
(3) Existence of Flotation costs : Flotation costs exist. That is,
when shares are issued in the market, issue expenses are
incurred by the company (by way of expenses paid to Merchant
Banker and others).
(4) Lack of Relevant Information : There is no lack of basic and
relevant information. All information are available in the
market.
(5) Taxes exist : Corporate taxes exist. Tax rate applicable to
dividend may be different from that of capital gains.
(6) No Fixed Investment Policy : There may not be a fixed
investment policy.
79
(7) Existence of Risk : There exists risk. All investors are not able
to forecast prices, profits and dividend with certainty. Hence
there is risk.
(8) Investor’s desire to obtain current income : The basic desire
of an investor may be to obtain current income and to have
diversification of portfolios.
Experts’ view on M-M Hypothesis :

Financial experts view that M-M theory of ‘irrelevance of
dividend’ is outdated to the present conditions. In fact,
dividends are relevant because these have information value.
Payment of dividends transmits a message of soundness and
profitability of a company. Company can make statements
about its anticipated earnings to create a favourable
impressions on the shareholders and on prospective investors.
80
(d) M-M Dividend Formula :
According to MM hypothesis, the market value of a share in the
beginning of the period is equal to the present value of dividends
paid at the end of the period plus the market price of the share at
the end of the period. This can be put in the form of the
following equation.
D1 + P1
(1) Formula-1 : P0 = ------------------
(1 + ke)
(2) Formula-2 : P1 = P0 x (1 + ke) – D1

(that is, D1 + P1 = P0 (1 + ke) derived from the above formula)
Explanation :
P0 = P (zero) = Present market price of a share,
Ke = Cost of equity capital,
D1 = Dividend to be received at the end of period one,
P1 = Market price of a share at the end of period one. 81
From the above equation, the following equation can be derived for
determining the value of P1.
(2) Formula : P1 = P0 (1 + Ke) – D1
(e) Computation of the number of new shares to be issued :

The investment programme of a firm in a given period of time, can
be financed either by retained earnings or by issue of new shares
or both. The number of new shares to be issued can be
determined by the following equation.
(3) Formula : m x P1 = I – (X – nD1)
where,
m = Number of new shares to be issued,
P1 = Price at which new issue is to be made,
I = Amount of investment required,
X = Total net profit of the firm during the period,
nD1 = Total dividends paid during the period.
82
Students should remember the following formulas :
(i) P0 (P zero) = (D1 + P1) / (1 + ke)
(ii) P1 = P0 (1 + ke) – D1
(formula –(ii) is derived from formula-(i) as under )
P0 = (D1 + P1) / (1 + ke) =
D1 + P1 = P0 (1 + ke) =
P1 = P0 ( 1 +ke) – D1
(iii) According to MM theory, the value of the company remains the

same irrespective of payment divide at any rate. Hence it is known
as irrelevance theory of dividend.
83
Modigliani and Miller's Approach :
(M-M model)
Problem-1
The share capital of Arvind Limited is Rs 10,00,000 divided

into 1,00,000 equity shares of Rs 10 each. The company is
contemplating a dividend of Rs 10 per share at the end of
the current year. The company belongs to a risk class
for which appropriate capitalisation rate is 20%. The
current market price of the share is Rs 100. What will be
the price of the share at the end of the year if
(a) dividend is not declared, and
(b) dividend is declared
(c) Write comments.
Solution – 1 :
Working Notes :
P0 = Current MPS = Rs 100
Ke = 20% = 0.20
D1 = Dividend paid after one
year
84
Solution – 1
(a) Market price when dividend is not declared :
( Current Market Price =
P0 = 100, Ke = 0.20 (20%),
D1 = 0 (since dividend not
declared)
Formula :
(adjusted formula see
page – 81)
P1 = P0 (1 + ke) - D1 =
100 (1 + 0.20) - 0
Rs 100 (1.2) = Rs 120
(b) Market price when dividend is declared :

P1 = P0 (1 + ke) - D1 =
100 (1 + 0.20) - 10 =
= (100 + 20) – 10 =
Rs 120 – 10 = Rs 110
Comments :
85
Problem-2 :
D Ltd belongs to a risk-class for which the appropriate
capitalisation rate is 10%. It has 25,000 shares outstanding.
The current market price of the share is Rs 100. The
company is contemplating the declaration of dividend of
Rs 5 per share at the end of the current year. The
company expects to have a net income of Rs 2,50,000
and has a proposal for making new investments of
Rs 5,00,000. You are required to calculate :
(i) Market price per share when dividend is declared,
(ii) Market price per share when dividend is not declared,
(iii) Number of new shares to be issued,
(iv) Show that the payment of dividend does not affect
the value of the company.
(v) Write comments.
(i) Calculation of market price when dividend is declared:
P1 = P0 (1 + ke) - D1 =
100 (1 + 0.1) - 5
Rs 100 x 1.1 - 5
110 - 5 = Rs 105
86
(ii) Calculation of market price when dividend is not declared :
P1 = P0 (1 + ke) - D1 =
100 (1 + 0.1) - 0 =
Rs 100 (1.1) = Rs 110
(iii) Calculation of number of new shares to be issued :
Note : To meet new investments of Rs 5,00,000, retained earnings

of Rs 1.25.000 is available.
Particulars Dividend Dividend not

declared declared
Net Income (Rs) 2,50,000 2,50,000
Less : Dividend paid (25000 x 5) 1,25,000 0
Retained earnings 1,25,000 2,50,000
New Investments 5,00,000 5,00,000
Amount to be raised by issue of new 3,75,000 2,50,000
shares (5,00,000 – 1,25,000)
Market price per share (see previous Rs 105 Rs 110
page)
Number of new shares to be issued: 375000 / 105 = 250000 / 110 =
3571 2273
87
(iv) Verification of MM Dividend Irrelevance Theory :
declared declared
Existing shares 25000 25000
New shares to be issued 3571 2273
Total Number of shares 28571 27273
Market price per shares Rs 105 Rs 110
Total market value of shares at the 29,99,955 30,00,030
end of the year (30,00,000 for both)
Say
30,00,000 for both
Comments :
Thus, whether dividends are paid or not, the value of the firm
remains the same.
In both the cases above, the market
value is Rs 30,00,000, hence
payment of dividend does not
change total market value of share.
As such, it is irrelevant as per MM
theory)
88
Problem-3 :
Bajaj Ltd has 1,20,000 shares outstanding and selling at
Rs 20 each in the market. The Company hopes to make a net
income of Rs 3,50,000 during the year ended 31st march 2009.
The company is considering to pay a dividend of Rs 2 per share
at the end of current year. The capitalisation rate for risk class
of this company has been estimated to be 15% using MM
Dividend
valuation model.
(a) What will be the price of a share at the end of the year
(i) if dividend is paid and (ii) if dividend is not paid ?
(b) How many new shares must the company issue if the dividend
is paid and the company needs Rs 7,40,000 for an approved
investment expenditure during the year ? Write
comments.
89
(a) Calculation of market price per share under
M-M Dividend valuation model :
Formula :
P1 = P0 ( 1 + ke) - D1
(i) If dividend is declared :
P1 = P0 ( 1 + ke) - D1 =
20 ( 1 + 0.15 ) - 2 =
20 ( 1.15) - 2 =
23 - 2 = Rs 21
(ii) If dividend is not declared :

P1 = p0 ( 1 + ke ) - D1
20 ( 1 + 0.15) – 0
20 (1.15) = Rs 23
Comments :
90
(iii) Calculation of number of shares of new shares to be issued:
declared declared
Net income (Rs) 3,50,000 3,50,000
Less : Dividend paid (120000 x 2) 2,40,000 0
Retained earnings (350000 – 240000) 1,10,000 3,50,000
New investments 7,40,000 7,40,000
Amount to be raised by issue of new 6,30,000 3,90,000
shares
Market price per shares 21 23
Number of new shares to be issued 6,30,000 / 21 = 3,90,000 / 23 =
30,000 16,957
91
Problem - 4
The expected earnings per share of a company are Rs 10. Equity
Capitalistion Rate is 10%. The current market price of share is
Rs 100. Under M-M model determine the market price of share
at the end of period 1 :
(a) When dividends are not declared
(b) When dividends are declared and payout ratio is 60%
(c ) When dividends are declared and payout ratio is 100%
(d) Write comments.
92
Solution - 4 :
Calculation of Market Price of share under M-M model at
payout ratio of 0%, 60% and 100%
Particulars 0% payout 60% payout 100% payout
ratio ratio ratio
P0 = Prevailing Market Price Rs 100 Rs 100 Rs 100

D1 = Dividend per share declared
at the end of period1 0.00 6.00 10.00
ke = Equity capitalisation rate 0.10 0.10 0.10
P1 = Market Price at the end of 100x(1+0.1) - 0 100x(1+0.1) - 6 100x(1+0.1) - 10
period 1 (Formula: P0(1 + ke) – D1)
P1 = P0 ( 1 + ke ) - D1 = Rs 110 Rs 104 Rs 100
Comments :
93
Problem – 5 (MMS – MU – Oct 2010)
The current market price of the shares of X Ltd is Rs 120 per share.
The company is considering Rs 6.40 per shares as dividend. The
company belongs to a risk class where the cost of capital (ke) is
9.6%. Using M-M approach you are required to determine the
market price of share, when
(a) Dividend is declared,
(b) Dividend is not declared,
(c ) Interpret your learnings from calculations of (a) and (b) above.
(d) Write comments.
According to M-M approach, the Market Value of share =
P0 = (D1 + P1) / (1 + Ke)
P0 = Current Market Price of share
ke = Cost of equity capital
D1 = Dividend to be expected at the end of period
P1 = Market price of share at the end of period
The above equation can be modified as under :

P1 = P0 ( 1 + ke ) - D1
94
(a) Calculation of Market Price of share of the
company when dividend is declared :
P1 = P0 ( 1 + ke ) - D1 =
120 ( 1 + 0.096) - 6.40
120 ( 1.096) - 6.40 = Rs 125.12
(b) Calculation of Market Price of share of the

company when dividend is not declared :
P1 = P0 ( 1 + ke ) - D1 =
120 ( 1 + 0.096) - 0 =
120 ( 1.096) = Rs 131.52
(c ) Learning out of the policy of dividend is that

the market price of equity shares of a company is
higher when dividend is not declared (compare
(a) and (b) above). It is lower when dividend is
declared based on M - M approach.
(d) Comments :
95
Problem - 6 :
(MMS – MU – Nov.2011)
Lever Ltd belongs to a risk class for which the
appropriate capitalisation rate is 12.5%. Currently
it has 1,00,000 shares selling at Rs 80 each. The
firm is contemplating the declaration of Rs 6
dividend at the end of the current fiscal year
which has just begun.
Based on M - M model and assumption of no taxes
you are required to :
(a) Calculate that the share price at the end of
the year, (i) if dividend is paid and
(ii) dividend is not paid.
(b) Assuming that the firm pays dividends, has
net income of Rs 25,00,000 and makes a new
investment of Rs 42,00,000 during the period,
how many new shares must be issued to maintain
the market price ? Write comments.
96
(i) Value of firm when dividend is paid :
P0 = (D1 + P1) / (1 + ke)
80 = ( 6 + P1 ) / ( 1 + 0.125)
80 x 1.125 = 6 + P1
90 - 6 = P1
P1 = Rs 84 MP of share = 84
(ii) Value of firm when dividends are not paid :

P0 = (D1 + P1) / ( 1 + ke)
80 = ( 0 + P1 ) / ( 1 + 0.125 )
80 ( 1 + 0.125 ) = P1
P1 = 80 + 10 = 90
P1 = Rs 90 MP of share = Rs 90
(iii) Amount required to be raised from the issue

of new shares :
(Net Income = 25 lakhs, Dividend
paid : 6 lakhs, Retaianed earnings :
19 lakhs)
No of additional shares =
Rs 42 lakhs - (25 lakhs - 6 lakhs) =
Rs 42 - 19 =
Rs 23 lakhs
No. of additional shares =

23,00,000 / 84 = 27,380.95
i.e. 27,381 shares
97
Problem – 7 : (home work)
ABC Company Limited currently has 3 lakhs outstanding shares selling
at Rs 100 each. The firm has net profit of Rs 30 lakhs and wants to
make new investments of Rs 60 lakhs during this period. The firm is
also thinking of declaring a dividend of Rs 15 per share at the end
of the current year. The firm’s opportunity cost of capital is 10%.
What will be the price of share at the end of the year, if (a)
dividend is not declared, (b) dividend is declared, (iii) How many
new shares must be issued ? Write comments.
The current market price of shares of X Ltd is Rs 120 per share. The
company is considering Rs 6.40 per share as dividend. The company
belongs to a risk class for which capitalisation rate is 9.60%. Based
on M-M approach, calculate the market price of the share of the
company when dividend is declared and when the dividend is not
declared. Write comments.
98
X Ltd has 8 lakhs equity shares outstanding at the beginning of
the year 2013. 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 capitalisation, appropriate to the
risk class to which the company belongs is 9.6%.
(i) Based on M-M approach, calculate the market price of the
share of the company, when (a) dividend is declared, and (b)
dividend is not declared.
(ii) How many new shares re to be issued by the company, if the
company desires to fund an investment budget of Rs 3.20
crores by the end of the year assuming net income for the year
will be Rs 1.60 crores ?
99
Problem-10 : (home work)
Agile Limited, belongs to risk class of which appropriate
capitalisation rate is 10%. It currently has 1,00,000 shares
selling at Rs 100 each. The firm is contemplating declaration of a
dividend of Rs 6 per share at the end of the current year which
has just began. Answer the following questions based on M – M
model and assumption of no taxes :
(i) What will be the price of the shares at the end of the year if a
dividend is not declared ?
(ii) What will be the price if dividend is declared ?
(iii) Assuming tht the firm pays dividend, has not income of
Rs 10 lakhs and makes new investments of Rs 20 lakhs during
the period, how many new shares must be issued ?
(iv) Write comments.
100
A chemical company belong to a risk class for which the appropriate
P/E ratio is 10. It currently has 50,000 equity shares outstanding
selling at Rs 100 each. The firm is contemplating the declaration
of dividend of Rs 8 per share in the current year, which has just
started. Given the assumption of M-M answer the following
questions :
(i) What will be the price of the share at the end of the year
(a) If dividend is not declared, and (b) if it is declared.
(ii) Assuming that the company pay the dividend, has a net income
of Rs 5,00,000 and makes new investments of Rs 10,00,000
during the period, how many new shares must be issued ?
101
Problem – 12 (home work)
A company belongs to a risk class for which the appropriate
capitalisation rate is 10%. It currently has outstanding 25,000
shares selling at Rs 100 each. The firm is contemplating the
declaration of dividend of Rs 5 per share at the end of the
current financial year. The company expects to have a net
income of Rs 2.5 lakhs and has a proposal for making new
investments of Rs 5 lakhs. Show that, under the M-M approach,
payment of dividend does not affect the value of the firm.
(hints : (i) calculate the market price per share if dividend is paid
(Rs 105) and (ii) dividend not paid (Rs 110), (iii) calculate
number of new shares to be issued (for (i) 3,571 shares and (ii)
2,273 shares), (iv) prepare verification table to show that total
market value of shares under (i) and (ii) is the same that is Rs
30 lakhs for (i) and (ii) both). Write comments.
102
DIVIDEND POLICY & DECISIONS :
Additional Problems & Mumbai Univ. Exam
problems and solutions.
(Count the number of problems continuously in ppt.)

From the beginning)
Problem No. 34
The earnings per share of B Ltd is Rs 4 and the
rate of capitalisation applicable is 10%. The
Company has an option of adopting (i) 50%,
(ii) 75% and (iii) 100% dividend pay-out ratio.
Compute the market price of the company's
share as per Walter's model if it can eacn a
return of 10% on its retained earnings.
Write comments.
103
Solution - 34 :
Computation of market price of company's
share :
Dividend Pay-out ratio : 50%, 75%, 100%
Walter Model formula :
P = [ D + (r / ke) (E - D) ] / ke
(i) Dividend Pay-out 50%
D = 50% of Rs 4 = Rs 2
E= 4
r = 10% (0.10)
Ke = 10% (0.10)
P = [ 2+ (0.10 / 0.10) / (4 - 2) ] / 0.10 =
4 / 0.10 = Rs 40
(ii) Dividend Pay-out 75%

D = 75% of Rs 4 = Rs 3
E= 4
r = 10% (0.10)
Ke = 10% (0.10)
P = [ 3+ (0.10 / 0.10) / (4 - 3) ] / 0.10 =
4 / 0.10 = Rs 40
(iii) Dividend Pay-out 100%

D = 100% of Rs 4 = Rs 4
E= 4
r = 10% (0.10)
Ke = 10% (0.10)
P = [ 4 + (0.10 / 0.10) / (4 - 4) ] / 0.10 =
4 / 0.10 = Rs 40
104
Problem - 35 :
Following are the details regarding three
companies X Ltd, Y Ltd and Z Ltd.
X Ltd Y Ltd Z Ltd
r = 15% r = 15% r = 10%
Ke = 10% Ke = 10% Ke = 10%
E = Rs 8 E = Rs 8 E = Rs 8
Calculate the value of equity share of each

of the company applying Walter's model;
when dividend pay-out ratio is (a) 50%,
(b) 75% and (c ) 25%. You are required to
offer your comments on the results.
105
Solution - 35
Walter's Model : Formula :
P = [ D + (r / ke) (E - D) ] / ke
Dividend Pay- X Ltd Y Ltd Z Ltd

out Ratio
(a) 50% P = [4 P = [4 +(0.05 / P = [4 + (0.10
+(0.15/0.10) / 0.10) (8-4)] / / 0.10) (8-4)] /
(8-4) ] / 0.10 = 0.10 = Rs 60 0.10 = Rs 80
Rs 100
(b) 75% P = [6 + P = [6 +(0.05 / P = [6 + (0.10
(0.15/0,10)(8- 0.10) (8-6)] / / 0.10) (8-6)] /
6)] / 0.10 = Rs 0.10 = Rs 70 0.10 = Rs 80
90
(c ) 25% P = [2 + P = [2 +(0.05 / P = [2 + (0.10
(0.15/0,10)(8- 0.10) (8-2)] / / 0.10) (8-2)] /
2)] / 0.10 = Rs 0.10 = Rs 50 0.10 = Rs 80
110
Comments :
The value of X Ltd share is the highest at Rs 110 when
dividend pay-out ratio is lowest i.e. 25%. The value of
y Ltd goes on declining with every increase in the earnings
retainedby it. In case of Z Ltd, the value of share continue
to be Rs 80 in all he three situations.
106
Problem - 36 (MMS, MU, Oct 2010)
ABC company Ltd is expecting 10% return on total
assets or Rs 50 lakhs. The company has outstanding
shares
20,000. The directors of the company have decided to pay
40% of earning as dividends. The rate of return required
by shareholders is 12.5%. Rate of return expected on
investment is 15%. You are required to determine the
price of the shares of the company using Walter's model.
Write comments.
107
Solution - 36 :
The value of share as per Walter model =
P = [D + (r / Ke) (E - D) ] / Ke
P = Market price of share
E = Earnings per shre
D = Dividend per share
(E - D) = Retained earnings per shre
r = Rate of return on investment
Ke = Capitalisation rate
Earnings = 10% of Rs 50 lakhs = Rs 5 lakhs
Earnings per Share (EPS) = 5,00,000 / 20,000 = Rs 25
Dividend = 40% of Rs 5,00,000 = Rs 2,00,000
Dividend per share = 2,00,000 / 20,000 = Rs 10
P = [D + (r / Ke) (E-D)] / Ke =
[10 + (15/12.5)(25-10) ] / 12.5 = (10 + 18) / 12.5 =
28 / 12.5% = (28 / 12.5) x 100 = Rs 224
Price of share of company = P = Rs 224
108
Problem - 37 : (MMS, MU, May 2012)
The following information is available in rspect of
a company :
Capitalisation Rae (Ke) = 0.12
EPS = Rs 15
Rate of return on investment = (1) 0.15, (2) 0.10
The company wants to know the effect on the market
price of its shares under the two possibilities of (r )
i.e. 0.15 and 0.10 under two options.
(a) If it does not declare any dividend, and
(b) If it declares Rs 15 as dividend.
Using Walter's model, explain the results obtained by you.
(Note : Same question was earlier given in
MMS, MU exam. December 2008)
Solution - 37 :
Calculation of Market Price of company' share :
Walter model ; Formula :
P = [D + (r / Ke) (E-D)] / Ke =
E = Earnings per share = Rs 15
D = Dividend per share = 0 and 15
(E - D) = Retained earnings per share
r = Rate of return on investment = 0.15 (15%) and 0.10 (10%)
Ke = Capitalistion rate = 0.12 (12%)
109
(a) If Dividend not declared :
(i) At rate of return at 15% (0.15)
P = [0 + (0.15 /0.12)(15-0)] / 0.12 =
18.75 / 0.12 = Rs 156.25
(ii) At rate of return at 10% (0.10)

P = [ 0 + (0.10 /0.12) (15 - 0) ] / 0.12 =
12.50 / 0.12 = Rs 104.17
(b) If Dividend is declared at Rs 15

(i) At rate of return at 15% (0.15) :
P = [ 15 + (0.15 / 0.12)(15 - 15) ] / 0.12 =
15 / 0.12 = Rs 125
(ii) At rate of return at 10% (0.10) :

P = [ 15 + (0.10 / 0.12) (15 - 15) ] / 0.12 =
15 / 0.12 = Rs 125
Interpretations :
(1) Using Walter's model the market price of a
share remains the same in case the value of
r' (rate of return) is changes and dividend is
declared by the company.
(2) However, the value of share is reduced
if the value of 'r' (rate of return) is reduced
and if the company does not declare
dividend.
110
Problem - 38 : (MMS, MU, Nov. 2012)
ABC company Ltd is expecting 10% return on
total assets of Rs 50 lakhs. The company has
outstanding shares of 20,000. The directors of
the company have decided to pay 40% of
the earnings as dividend. The rate of return
required by the shareholders is 12.5%. Rate of
return expected on investment is 15%. You are
required to determine the price of the share
as per Walter's model. Write
comments.
(Note : MMS Oct 2010 question is repeated
again as it is)
Solution - 38 :
Computatin of price of share price as per
Walter's model :
P = [D + (r / Ke) (E - D) ] / Ke
PAT = 10% on 50 lakhs = Rs 5,00,000
EPS = 5,00,000 / 20,000 shres = Rs 25
Dividend = Rs 10
r (Rate of return) = 15%
Ke = 12.50%
Price per share =

P = [10 + (15 / 12.50) (25 - 10) ] / 12.50 % =
(10 + 18) / 12.50 % = (28 / 12.50) x 100 = Rs 224
Price of share = P = Rs 224
111
Problem - 39 :
The cost of capital and rate of return on
investments of WM Ltd is 10% and 15%
respectively. The company has one million
equity shres of Rs 10 each outstanding and
its earnings per share is Rs 5. Calculate the
value of share in the following situation,
using Walter's model :
(i) 100 retentin of earnings
(ii) 50% retention of ernings
(iii) No retention of earnings
(iv) Write comments.
Solution - 39 :
P = [D + (r / Ke) (E - D) ] / Ke
EPS = E = Rs 5
r = rate of return = 15% (0.15)
Ke = 10% (0.10)
112
(i) Under 100% retention, dividend
pay-out will be zero, hence
P = [ 0 + (0.15 / 0.10) (5 - 0) ] / 0.10 = Rs 75
(ii) 50% retention means , dividend pay-out is

50% (50% of Rs 5 = Rs 2.50)
P = [2.50 + (0.15 / 0.10) (5.00 - 2.50) ] / 0.10 =
Rs 62.50
(iii) No retention means 100% pay-out of dividend

EPS = Dividend paid = Rs 5
P = [5 + (0.15 / 0.10) (5.00 - 5.00) ] / 0.10 =
Rs 50
Comments : Since the rate of return is higher

than the cost of capital, any retention will
contribute in increasing the market value of
share.
113
The following data is available for Modi Co. Ltd.
Earnings per share : Rs 2
Internal Rae of Return : 18%
Cost of Capital : 16%
If Walter's Valuation formula holds, what will be
the price per share when the dividend payment
ratio is 50%, 80%, and 100%.
Write comments for your
answer.
Solution - 40 :
According to Walter Model formula :
P = [ D + (r / Ke) (E - D) ] / Ke
P = Price of equity share
D = Dividend per shre
E = Earnings per share
(E - D) = Retained Earnings per share
Ke = Cost of Capital
114
Workings for Div. per share :
Dividend pay-out 50% 80% 100%
EPS 2 2.00 2
Dividend per share 1 1.60 2
Retained earnings 1 0.40 0
(i) When dividend pay-out is 50%

P = [ 1 + (0.18 / 0.16) (2 - 1) ] / 0.16 =
(1 + 1.125) / 0.16 = 2.125/0.16 = Rs 13.28
(ii) When Dividend pay-out is 80% :

P = [ 1.60 + (0.18 / 0.16) (2 - 1.60) ] / 0.16 =
(1.60 + 0.45) / 0.16 = 2.05 / 0.16 = Rs 12.81
(iii) When Dividend pay-out is 100% :

P = [ 2 + (0.18 / 0.16) (2 - 2) ] 0.16 =
( 2 + 0) / 0.16 = 2 / 0.16 = Rs 12.50
115
Vikas Company Ltd has a total investment of
Rs 5,00,000 in assets and 50,000 equity shares
of Rs 10 each (par value). It earns a rate of
15% on its investment and has a policy of
retaining 50% of the earnings. If the approximate
discount rate of the firm is 10% determine the
price of its share using Gordon's model.
What shall happen to the price of the share,
if the company has a pay-out of 80% or 20%.
Write comments.
Solution - 41 :
Gordon's Model of share valuation :
Formula :
P0 = E1 (1 - b) / (Ke - br)
P0 (zero) = Current market price of eq. share
E1 = Expected earnings per share
b = Retention ratio of earnings
(1 - b) = Div. pay-out ratio
br = g = Expected future growth rate of
earnings and dividends
116
Working notes :
EPS (E1) = PAT / No. of shares =
(5,00,000 x 0.15) / 50,000 = Rs 1.50
(i) If dividend pay-out is 50% (retention: 50%)

P0 = 1.5 x (1 - 0.50) / 0.10 - (0.50 x 0.15) =
0.75 / 0.025 = Rs 30
(ii) If dividend pay-out is 80% (retention : 20%)

P0 = 1.5 x (1 - 0.20) / 0.10 - (0.20 x 0.15) =
1.20 / 0.07 = Rs 17.14
(iii) If dividend pay-out is 20% (retention: 80%)

P0 = 1.5 x (1 - 0.80) / 0.10 - (0.80 x 0.15) =
0.30 / (-) 0.02 = Rs (-) 15
Note : Negative share price is not possible in

reality, because seller will not sell the shares
unless he get market price for his shares from
the buyer. In such an event, the share will not be
traded and the market price of share will be NIL.
117
Problem - 42 :
(M-M Model)
ABC Company Ltd currently has 3 lakh equity
shares selling at Rs 100 each. The firm has
net profit of Rs 30 lakhs and wants to make new
investments of Rs 60 lakhs during this period.
The firm is also thinking of declaring a dividend
of Rs 15 per share at the end of current fiscal
year. The firm's opportunity cost of capital is
10%. What will be the price of share at the end
of the year if the following situations are
considered :
(a) A dividend is not declared
(b) A dividend is declared
(c ) How many new shares must be issued ?
(d) Write comments.
Solution - 42 :
This problem is based on M - M model. Formula
for M _ M model is as under :
(i) P0 = (D1 + P1) / (1 + Ke)
P0 = P(zero) = Present market price of a share
D1 = Dividend to be received at the end of period one
P1 = Market price of a share at the end of period one
118
(ii) From the above, the following formula can be
derived for determining the value of P1
P1 = P0 (1 + Ke) - D1
(explation : see above)
(a) Market Price of share w hen dividend is not

declared :
P1 = P0 (1 + Ke) - D1 =
100 ( 1 + 0.10) - 0 = 100 (1.1) = Rs 110
Market Price of share = Rs 110
w hen dividend is not declared
(b) Market price per share when dividend is

declared :
P1 = P0 (1 + Ke) - D1 =
100 (1 + 0.10) - 15 = 100 (1.10) - 15 =
110 - 15 = Rs 95
Market Price of shre = Rs 95 w hen div. is declared
(c ) Calculation of number of new shares to be issued:

Particulars Dividend not Dividend
declared declared
New investment Rs 60 lakhs Rs 60 lakhs
Market price per share 110 95
Num ber of new shares to 54,545.45 63,157.89
be issued
No. of shares (rounded 54,545 63,158
off)
119
The current market price of the shares of X Ltd is
Rs 120 per share. The company is considering
Rs 6.40 per shre as dividend. The company belongs
to a risk class for which capitalisation rate is 9.60%.
Bsed on M-M approach calculate the market price of
the share of the company when dividend is declared
and when dividend is not declared.
Write comments.
120
Solution - 43 :
This problem is based on M - M model. Formula

for M - M model is as under :
Formula : P1 = P0 (1 + Ke) - D1
(i) When Dividend is declared :

P1 = P0 (1 + Ke) - D1 =
120 ( 1 + 9.6%) - 6.40 = 120 ( 1+ 0.096) - 6.40 =
131.52 - 6.40 = Rs 125.12
Market price of share = Rs 125.12 (when div. declared)
(ii) When dividend is not declared :

P1 = P0 (1 + Ke) - D1 =
120 ( 1 + 0.096) - 0 = Rs 131.52
Market price of share = Rs 131.52 (when dividend
is not declared by the company)
121
Problem - 44 : (IMPORTANT PROBLEM)
(MMS, MU, Nov. 2013 and May 2014)
The following data is available for Newton Limited :
Earnings per share = Rs 6.00
Rate of return = 18%
Cost of Capital = 15%
(a) If Walter' valuation formula holds, what will be
the price per share when dividend pay-out ratio is
30% and 40% ?
(b) If Gordon's basic valuation formula holds, what
will be price per share when the dividend pay-out
is 30% and 40% ?
(c) Write comments.
Walter's Formula :
P = [ D + (r / Ke) (E - D) ] / Ke
P = Price of equity share
D = Dividend paid per share
E = Earnings per share
(E - D) = Retained Earnings per share
Ke = Cost of Capital
122
Workings for Div. per share :
Dividend pay-out 30% 40%
EPS 6.00 6.00
Dividend per share (6 x 30%) 1.80 2.40
Retained earnings(6 x 70%) 4.20 3.60

P = [ 1.80 + (0.18 / 0.15) (6 - 1.80) ] / 0.15 =
(1.80 + ( 1.20)( 4.20) / 0.15 = 1.80 + 5.04 / 0.15 =
6.84 / 0.15 = Rs 45.60
Market Price of share = P = Rs 45.60

P = [ 2.40 + (0.18 / 0.15) (6 - 2.40) ] / 0.15 =
(2.40 + ( 1.20)( 3.60) / 0.15 = 2.40 + 4.32 / 0.15 =
6.72 / 0.15 = Rs 44.80
Market Price of share = P = Rs 44.80
123
Gordon's Formula :
P0 = E1 (1 - b) / (Ke - br)
P0 (zero) = Current market price of eq. share
E1 = Expected earnings per share
b = Retention ratio of earnings
(1 - b) = Div. pay-out ratio
r = Rate of return on
investment
Calculations under Gordon's formula :

(i) If dividend pay-out is 30%
:
Hence retention is 70%
P0 = 6 x (1 - 0.70) / 0.15 - (0.70 x 0.18) =
6 - 4.20 / 0.150 - 0.126 = 1.80 / 0.024 = Rs 75
Market Value of share is Rs 75
(i) If dividend pay-out is 40%

:
Hence retention is 60%
P0 = 6 x (1 - 0.60) / 0.15 - (0.60 x 0.18) =
6 - 3.60 / 0.150 - 0.108 = 2.40 / 0.042 = Rs 57.14
Market value of share = Rs 57.14
Comments :
124
Problem - 45 : (MMS, MU, May 2014)
(MMS, MU, Nov. 2012 (modified question)
X Ltd has 8 lakhs equity shares outstanding at the
beginning of the year 2013. The current market
price per shre is Rs 120. The Board of Directors of the
company is contemplating Rs 6.40 per share as
dividend.
The rate of capitalisation, appropriate to the risk
class to which the company belongs is 9.6%.
(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 crores by the end of
the year, assuming net income for the year will be
Rs 1.60 crores.
125
Solution - 45 :
(i) This problem is based on M - M model. Formula
for M - M model is as under :
Formula : P1 = P0 (1 + Ke) - D1
(a) When Dividend is declared :

P1 = P0 (1 + Ke) - D1 =
120 ( 1 + 9.6%) - 6.40 = 120 ( 1+ 0.096) - 6.40 =
131.52 - 6.40 = Rs 125.12
Market price of share = Rs 125.12 (when div. declared)
(b) When dividend is not declared :

P1 = P0 (1 + Ke) - D1 =
120 ( 1 + 0.096) - 0 = Rs 131.52
Market price of share = Rs 131.52 (when dividend
is not declared by the company)
Comments :
126
(ii) Calculation of No. of new shares to be issued :
Particulars If dividend If dividend
paid not paid
(a) Net Income 1,60,00,000 1,60,00,000
(b) Less : Dividend paid 51,20,000 0
(6.40 x 8,00,000)
(c )Retained earnings 1,08,80,000 1.60,00,000
(d) Investment budget 3,20,00,000 3,20,00,000
(e) Additional amount 2,11,20,000 1,60,00,000
required for investment
(diff. between (d) and (c )
above)
(f) Market price per share 125.12 131.52
(g) No. of new equity 1,68,797.95 1,21,654.50
shares to be issued [ (e)
divided by (f)]
(h) No. of new shares to 1,68,798 1,21,655
be issued (rounded off)
127
To Cross Check :
Particulars Dividend paid Div. not paid
Existing No. of shares 8,00,000 8,00,000
New shares issued 1,68,798 1,21,655
Total No. of shares 9,68,798 9,21,655
Market Price of shares 125.12 131.52
Value of the Company
(9,68,798 x 125.12) = 12,12,16,005
(9,21,655 x 131.52) = 12,12,16,065
Note : The Market Value of the company is same.

Comments :
According to M-M approach, there is no change or
effect on the value of the company with respect to
dividemnd paid as proved above.
128
THANK YOU
129

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Pillai Institute of Management Studies and

Master of Management Studies (MMS)

Chapter - 6 : Dividend Policy and

(1) General state of economy: In case of uncertain economic and

(7) Forms of dividend :

(8) Dividend Policy Formulation :

(9) Legal and Procedural aspects of dividends :

(ii) Procedural Aspects :

(10) Theories of Dividend :

(ii) Theory of Irrelevance :

(i) Theories of Relevance (Relevance concept of dividend) : Theories

(c) Assumptions of Walter’s model :

Formula : P = [D + (r / Ke) x (E – D) ] / (ke /100)

P = Market price per equity share (MPS)

Distributable profit to eq. shareholders

Total amount of dividend paid

Dividend paid per share

Market price per share (MPS)

(vii) Market Price per share = EPS x PE Ratio

Earnings per share EPS

(ix) Cost of Capital = (1 / PE Ratio) x 100

(x) Dividend Pay-out = EPS (1 – Retention % of Profit)

Dividend paid = (Total Amount of dividend / No. of Eq. shares)

(1) First, write formula,

investment at 20%. According to Walter's Model

Dividend = D = 6 x (30/100) = 1.80

Market Value of share = P =

P = [1.80 (+) (2.0 x 4.20)] / 0.10

P = [1.80 + 8.40] / 0.10

P = 10.20 / 0.10 = 102

Comments: : As per the calculation of

(i) Market price per share if pay-out is zero :

Market price per share = P =

P = [ 0 (+) (1.20 x 5)] / 0.10

Comments : r = 12.5% and ke =

Market price per share = P =

P = [ 1 (+) (1.20 x 4)] / 0.10

Comments : As per Walter’s

Market price per share = P =

P = [ 2 (+) (1.20 x 3)] / 0.10

Comments: Higher dividend

It is proved in this problem :

(i) Market price per share if pay-out is 20% :

Market price per share(MPS) =

P = [ 4 (+) (1.25 x 16)] / 0.12

Market price per share = P =

P = [ 12 (+) (1.25 x 8)] / 0.12

Market price per share = P =

P = [ 20 (+) (1.25 x 0)] / 0.12

The cost of capital and rate of return on investment of

10,00,000 equity shares of Rs 10 each outstanding and

earnings per share is Rs 5. Calculate the value of the firm

in the following situations. Use Walter's model and comment

on the results. (i) 100% retention of earnings,

(i) Market price per share at 100% rention of profits :

Market price per share = P =

P = [ 0 (+) (1.50 x 5)] / 0.10

Note : If 100% of profit is retained, dividend pay-out is

Market price per share = P =

P = [ 2.50 (+) (1.50 x 2.50)] / 0.10

P = [ 2.50 + 3.75 ] / 0.10

P = 6.25 / 0.10 = 62.50

Market price per share(MP) = P