FINANCIAL MANAGEMENT

Dividend decision
QUESTIONS

DIVIDEND GROWTH MODEL

Question No. 1
A firm had been paid dividend at Rs. 2 per share last year. The estimated growths
of the dividends from the company is estimated to be 5% p.a. Determine the
estimated market price of the equity share. Also calculate MPS if the estimated
growth rate of dividends (i) rises to 8%, and (ii) falls to 3% .Given that the required
rate of return of the equity investors is 15.5%.

Ans: Estimated price = Rs. 20; i. Rs.28.80; ii. 16.48

Question No. 2
A share of Tension-free Economy Ltd. is currently quoted at, a price earnings ratio
of 7.5 times. The retained earnings per share being 37.5% is Rs.3 per share.
Compute:
I. The company’s cost of equity, if investors expect annual growth rate of 12%.
II. If the anticipated growth rate is 13% p.a., calculate the indicated market price,
with same cost of capital.
III. If the company’s cost of capital is 18% and anticipated growth rate is 15% p.a.,
calculate the market price per share, assuming other conditions remain the
same.

Ans: (I) Ke = 20.33% p.a; (II) Market price = Rs. 68.21; (III) Market Price = Rs. 166.66

Question No. 3
In December, 2011 AB Co.'s share was sold for 146 per share. A long term
earnings growth rate of 7.5% is anticipated. AB Co. is expected to pay dividend of `
3.36 per share.

I. What 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?
II. It is expected that AB Co. will earn about 10% on book Equity and shall retain
60% of earnings. In this case, whether, there would be any change in growth
rate and cost of Equity
Ans: (I) ke = 9.80%; (II) G = 6%, Ke = 8.30%
Question No. 4
On the basis of the following information:
Current dividend (DO) =Rs.2.50
Discount rate (k) =10.5%
Growth rate (g) =2%
I. Calculate the present value of stock of ABC ltd.
II. Is its stock overvalued if stock price is Rs.35, ROE=9% and EPS=Rs.2.25?
Show detailed calculation.
Ans: (I) Present value = 30; (ii) yes; calculated value is Rs.21.52 only.

Question No. 5

The risk free return is 10% and the risk premium is 5% with beta of a company is
1.6. The company has declared the latest dividend @ Rs.3 (2002) whereas it has
declared a dividend of Rs. 2.115 in the year 1996. The company’s earnings and the
dividend experienced constant growth. Find out the intrinsic value of the shares.
Take into account the following PV factor table value if useful.
Percentage of cost of capital PV Values at the end of 6 years
5% 0.746
6% 0.705
7% 0.666

Ans: Intrinsic value per share = 26.50

Question No. 6
Sarah Ltd currently pays a dividend of Nrs. 20 per shares and this dividend is
expected to grow at a 15% annual rate for 3 years, then at a 10 percent rate for the
for the next three years, after which it is expected to grow at a 5% are forever.
What value would place on stock if an 18% percent rate of return were required?

Ans : Rs. 393.85

Question No. 7

Vinay Ltd. has been regularly paying a dividend of Rs.15, 00,000 p.a. for several
years. It is expected that dividend would continue at this level in near future.
There are 10 lakhs equity shares of Rs.10 each (being traded at par.)

The company has an opportunity to invest Rs.10, 00,000 in one year’s time and a
similar amount in two years’ time in a project that will generate an equal cash flow
of Rs.4, 00,000p.a. Forever starting in three years’ time. The only possible way of
financing this investment is by paying a reduced dividend for the next two years
to the shareholders.
Analyze the effect on the market price of the share, if the company decide to go
ahead with the project.
Ans: Existing value per share Rs. 10 will increase by 0.39 ( i.e. Value = 10.39)
Question No. 8

A share of the face value of Rs. 100 has current market price of Rs.480. Annual
expected dividend is 30%.During the fifth year, the shareholder is expecting a
bonus in the ratio of 1:5. Dividend rate is expected to be maintained on the
expanded capital base. The shareholder intends to retain the share till the end of
the eighth year. At that time, the value of share is expected to be Rs. 1,000.
Incidental expenses at the time of purchase and sales are estimated at 5% on the
market price. There is no tax on dividend income and capital gain. The
shareholder expects a minimum return of 15% per annum.

Should he buy the share? What is the maximum price he can pay for the share?
Show complete working.

Ans: NPV = 13.21, hence he should buy; Max price per share = Rs.492.58
Question No. 9

Purnima Wool House is a manufacturer and exporter of woolen garments to

most of the European countries and to United States of America. The business of
the company is expanding day by day and in the previous financial year, the
company has registered a 25% growth in export business.
The company is in the process of considering the new investment project. It is an
all equity financed company with 500,000 equity shares of face value of Rs. 100
per share. The current market price of this share is Rs. 250 ex-dividend. Annual
earnings are Rs. 50 per share, and in the absence of new investment, this will
remain constant in perpetuity. All earnings are distributed at present. A new
investment is available which will cost Rs. 17,500,000 in one year’s hence time
and will produce annual cash inflows thereafter of Rs. 5,000,000.
Required: Analyze the effect of the new project on dividend payment and share
price of the company.
Ans; Share price = Rs. 262.50
Question No. 10
Asha Limited expects, with some degree of certainty to generate the following
profits and to have the following investments during the next five years.
(In thousands)
Year 1 2 3 4 5
Net Income 10,000 8,000 5000 4,000 3,000
Investments 5,000 5,000 6,400 8,000 10,000

If the investments are financed first from the same year profit and the shortfall, if
any shall be externally financed.
The company has currently has 1,000,000 equity shares and pays dividend of Rs.
5 per share.
Required:
i. Determine dividend per share, if dividend policy is treated as a residual
decision
 ii. Determine dividend per share and the amount of the external financing
that will be necessary, if a dividend payout ratio of 50% is maintained.
Ans: i. 8 ; ii. 15 & 19.40 crores

Question No. 11

Ms. Jyoti purchased 100 shares of A Ltd. on 1.4.2002 at the market price of Rs.30.
On 1.4.2006, the company made a bonus issue of 2:5. He sold all the shares on
31.3.2008 at the market price of Rs. 50 per share (cum-dividend). He had to pay
tax@20% on his dividend income and @ 15% on capital gains.
If the company pays a regular dividend @10%, find out whether investor X was
able to earn his required rate of return of 10% on his investments.
(Present value factors @10% for 1-6 years are .91, .83, .75, .68, .62 and .56.)

GORDON’S MODEL
Question No. 12
A firm’s has a cost of equity 21.2% and its EPS is 12. The firm is planning to
declare 45% of this as dividends. If the firm reinvests its retained earnings at the
rate of 14%, what is the present market price of share according to Gordon
dividend capitalization model? Ans : Rs. 40

Question No. 13
The following information is collected from the annual reports of Prerana Ltd:

Profit before tax ` 2.50 crore

Tax rate 40 percent
Retention ratio 40 percent
Number of outstanding shares 50,00,000
Equity capitalization rate 12 percent
Rate of return on investment 15 percent
What should be the market price per share according to Gordon's model of
dividend policy? Ans : Rs.30
Question No. 14

The following figures are collected from the annual report of XYZ Ltd.:

Net Profit `30 lakhs

Outstanding 12% preference shares `100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%
Calculate price per share using Gordon’s Model when dividend pay-out is (i)
25%; (ii) 50% and (iii) 100%.

WALTER MODEL
Question No. 15

Eshan & Co. earns ` 6 per share having capitalisation rate of 10 per cent and has
a return on investment at the rate of 20 per cent. According to Walter’s model,
what should be the price per share at 30 per cent dividend payout ratio? Is this
the optimum payout ratio as per Walter?
Ans: Po = 102; This is not the optimum payout ratio because r > Ke and therefore Po
can further go up if payout ratio is reduced

Question No. 16
Swastika locks Ltd. was started a year back with equity capital of ` 40 lakhs. The
other details are as under:

Earnings of the company ` 4,00,000

Price Earnings ratio 12.5
Dividend paid ` 3,20,000
Number of Shares 40,000
Find the current market price of the share. Use Walter's Model.
Find whether the company's D/ P ratio is optimal, use Walter's formula.
 Ans: i. Po = 131.25; ii. 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 pay-out
ratio decreases. Hence, the optimum dividend pay-out ratio in this case is nil.
So, at a pay-out ratio of zero, the market value of the company’s share will be: Rs. 156.25

Question No. 17

The earnings per share of a company is ` 10 and the rate of capitalisation

applicable to it is 10 per cent. The company has three options of paying dividend
i.e. (i) 50%, (ii) 75% and (iii) 100%.
Calculate the market price of the share as per Walter’s model if it can earn a
return of (a) 15, (b) 10 and (c) 5 per cent on its retained earnings.

Question No. 18
The following information is supplied to you :
Total Earning ` 40 Lakhs
No. of Equity Shares (of ` 100 each) 4,00,000
Dividend Per Share ` 4
Cost of Capital 16%
Internal rate of return on investment 20%
Retention ratio 60%
Calculate the market price of a share of a company by using:
i. WaIter’s Formula
ii. Gordon's Formula Ans i. 71.88; ii. 100
MM HYPOTHESIS
Question No. 19
ZX Ltd. has a paid-up share capital of Rs.1,00,00,000, face value of Rs.100 each.
The current market price of the shares is Rs.100 each. The Board of Directors of
the company has an agenda of meeting to pay a dividend of 50% to its
shareholders. The company expects a net income of Rs.75,00,000 at the end of
the current financial year. Company also plans for a capital expenditure for the
next financial year for a cost of Rs.95,00,000, which can be financed through
retained earnings and issue of new equity shares.
Company’s desired rate of investment is 15%.
Required:
Following the Modigliani- Miller (MM) Hypothesis, DETERMINE value of the
company when:
i. It does not pay dividend and
ii. It does pay dividend

Question No. 20
Stopgo Ltd, an all equity financed company, is considering the repurchase of `
200 lakhs equity and to replace it with 15% debentures of the same amount.
Current market Value of the company is ` 1140 lakhs and it's cost of capital
is 20%. It's Earnings before Interest and Taxes (EBIT) are expected to remain
constant in future. Its entire earnings are distributed as dividend. Applicable tax
rate is 30 per cent.
You are required to calculate the impact on the following on account of the
change in the capital structure as per Modigliani and Miller (MM) Hypothesis:
i. The market value of the company
ii. It's cost of capital, and
iii. It’s cost of equity
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