Programme: MBA Semester-II (CBCS- OUTCOME BASED)

Course:- Financial Management

Module 5 : Dividend Policy

Module-5:Dividend Policy: Walter’s Model; Gordon’s Model and MM

Hypothesis for Dividend Policy and Firm Valuation, Determinants and
constraints of dividend decision

CO5: Given the expected dividends, future price of shares, investor

expectations and funding requirements; the future manager will be able to
compute the value of a share using various dividend discount models and
illustrate whether dividend is relevant for firm valuation or not.

Walter’s Model Relevance Theory

PROBLEM 1
The earning per share of Zoom Company Ltd. is Rs. 10 and the
Capitalization rate is 10% and return on investment is 12% .

Determine the optimum dividend payout ratio using Walter’s Model and
Compute the market price of the Company’s share if the Dividend payout
ratio is a) 25% b) 50% c)75% & d) 100% (ICAI Study Material)

PROBLEM 2

The following figures are collected from the annual report of Webex
Ltd.:
Particulars Rs.
Net Profit in Rs. 30,00,000
12% Preference Shares Capital in Rs. 1,00,00,000
No. of equity shares 3,00,000
Return on Investment 20%
Cost of capital i.e. (Ke) 16%
Compute the approximate dividend pay-out ratio so as to keep the share
price at Rs.42 by using Walter’s model? (ICAI Study Material)
PROBLEM 3
Following are the details regarding three companies A Ltd., B Ltd. and
C Ltd.:
A Ltd B Ltd C Ltd
r= 15% r = 5% r = 10%
ke = 10% ke = 10% ke = 10%
E = Rs.8 E = Rs.8 E = Rs.8.

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 Programme: MBA Semester-II (CBCS- OUTCOME BASED)
Course:- Financial Management
Module 5 : Dividend Policy

Calculate the value of an equity share of each of these companies applying

Walter's formula when dividend payment ratio {D/P ratio) is : (a) 25%, (b)
50%, (c) 75%. What conclusions do you draw ? (Rustagi Page No.302;
Problem No.14.5)

PROBLEM 4

The earnings per share of a Company are Rs. 8 and the rate of
capitalization applicable to the company is 10%. The company has before
it an option of adopting a payment ratio of 25% or 50% or 75%. Using
Walter's formula of dividend payout compute the market value of the
company's share if the productivity of retained earnings is (i) 15%, (ii) 10%,
and (iii) 5%. (Rustagi Page No.302; Problem No.14.3)

PROBLEM 5

The earnings per share of a company are Rs. 10. It has rate of return
of 15% and the capitalization rate of risk class is 12.5%. If Walter's model
is used (i) What should be the optimum payout ratio of the firm? (ii) What
would be the price of the share at this payout? (iii) How shall the price of the
share be affected if a different payout was employed? (Rustagi Page No.302;
Problem No.14.4)
PROBLEM 6
The earnings per share of a share of the face value of Rs. 100 of PQR
Ltd. is Rs. 20. It has rate of return of 25%. Capitalization rate of its risk
class is 12.5%. If Walter's model is used:
a) What should be the optimum payout ratio?
b) What should be the market price per share if the payout ratio is
zero?
c) Suppose, the company has a payout of 25% of EPS, what would be
the price
per share? (Rustagi Page No.303; Problem No.14.6)
PROBLEM 7

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 Programme: MBA Semester-II (CBCS- OUTCOME BASED)
Course:- Financial Management
Module 5 : Dividend Policy

The earning per share of ABC Ltd. is Rs. 10 and rate of

capitalization applicable to it is 10%. The company has before it the options
of adopting a pay-out of 20% or 40% or 80%. Using Walter’s formula,
compute the market value of the company's share if the productivity of
retained earnings is (i) 20% (ii) 10%, or (iii) 8%.
(Rustagi Page No.303; Problem No.14.7)
PROBLEM 8
Determine market value of equity shares of the company from the following
information as per Walter's Model :

Earnings of the company Rs.5,00,000

Dividend paid Rs. 3,00,000
Number of shares outstanding 1,00,000
Price-earning ratio 8
Rate of return on investment 15%
Are you satisfied with the current dividend policy of t he firm? If not
what should be the optimal dividend payout ratio? (Rustagi Page No.304;
Problem No.14.9)
PROBLEM 9
ABC and Co. has been following a dividend policy which can maximize
the market value of the firm as per Walter's model. Accordingly, each
year, at dividend time the capital budget is reviewed in conjunction with
the earnings for the periods and alternative investment opportunities for
the shareholders.
In the current year, the firm expects earnings of Rs. 5,00,000. It is
estimated that the firm can earn Rs. 1,00,000 if the profits are retained.
The investors have alternative investment o pp or t u ni ty that will yield
them 10% return. The firm has 50,000 shares outstanding. What shoul d
he the d i v i d e n d payout ratio in order to maximize the w ea lt h of t he
shareholders? Also find out the current market price of the share.
(Rustagi Page No.304; Problem No.14.11)
PROBLEM 10

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 Programme: MBA Semester-II (CBCS- OUTCOME BASED)
Course:- Financial Management
Module 5 : Dividend Policy

The earnings per share of a company are Rs. 16. The market rate of
discount applicable to the company is 12.5%. Retained earnings can be
employed to yield a return of 10%. The company is considering a pay-
out of 25%, 50% and 75%. Which of these would maximize the wealth of
shareholder? Walter's model. (Rustagi Page No.303; Problem No.14.8)
PROBLEM 11
Calculate the market price of a share of ABC Ltd. under (i)
Walter's formula; and (ii) dividend growth the model from the
following data :
Earnings per share Rs.5
Dividend per share Rs.3
Cost of capital 16%
IRR on investment
20%
Retention ratio 40%
(Rustagi Page No.305; Problem No.14.13)
PROBLEM 12
From the following information supplied to you, ascertain whether the
firm is following an optimal dividend policy as per Walter's model ?

Total earning’s Rs.2,00,000

Number of equity shares (of Rs. 100 each) 20,000
Dividend paid Rs.1,50,000
Price/Earning ratio 12.5
The firm is expected to maintain its rate of return on fresh investment. Also
find out what should be the P/E ratio at w h i c h the di vi de n d policy
w i l l have no effect on the value of the share? Will your decision change if
the P/E ratio is 8 instead of 12.5? (Rustagi Page No.305; Problem
No.14.12)

Gordon’s Model : Relevance Theory

PROBLEM 13

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 Programme: MBA Semester-II (CBCS- OUTCOME BASED)
Course:- Financial Management
Module 5 : Dividend Policy

A Company has a total investment of Rs. 5,00,000 in assets, and

50,000 outstanding common share at Rs. 10 per shares (par value).
It earns a rate of 15% on its investment, and has a policy of
retaining 50% of the earnings, if the appropriate discount rate of the
firm is 10 percent, determine the price of its share using Gordon's
model. What will happen to the price of the share if the company has
payout of 80% or 20%? (Rustagi Page No.305; Problem No.14.14 &
14.15)
PROBLEM 14
The following information is available in respect of ABC Ltd.

EPS Rs. 10
Rate of return 20%
Required rate of return of equity investment, ke 16%
Find out the market price of the share under Gordon model if the
firm follows a payout of 50% or 25%. (Rustagi Page No.525 old; Problem
No.11.11)

PROBLEM 15

Hindustan Home Product Ltd. has 2,00,000 shares of Rs. 100 each
fully paid up. The EPS and DPS for last 4 years are as follows :
Year -1 Year-2 Year - 3 Year-4 Total
EPS 11 12.40 10.90 17.20 50.40
DPS 10 10.90 11.88 12.95 45.73

The company has a policy (if increasing t h e annual d i v i d e n d s by

9 % p.a., a nt ic ip a t in g that this would m a i n t a i n the p u r c h a s i n g power
of the shareholders. However, actual infla t ion rate d u r i n g the year 2,3 &
4 had been 11%, 10 % and 8% respectively.

The share is cu r r ent ly being traded at Rs.344. You are r equ ir ed to

cri ti ca lly eva luat e the d i v i d e n d policy of the firm. Also find o u t the
cost of equit y capital on the basis of Constant g r o w t h rate Dividend
model.
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 Programme: MBA Semester-II (CBCS- OUTCOME BASED)
Course:- Financial Management
Module 5 : Dividend Policy

PROBLEM 16
The following information is available in respect of return on investment the
cost of capital and Earning Per Share of ABC company Ltd., r=10%;E= Rs.
40 determine the value of its share using Gordon’s Model assuming the
following:
Polic D/P Ratio (1-b) Retention Ratio (b) Cost of equity (Ke)
y
a) 20 80 20
b) 40 60 18
c) 60 40 16
d) 80 20 14
(Sharma Gupta Page No. 25.09 Problem No.5)
PROBLEM 17
A company is expected to pay a dividend of Rs. 6 per share next year The
dividend are expected to grow perpetually at a rate of 9%.What is the value
of its share if the required rate of return is 15%? (Sharma Gupta Page No.
25.10 Problem No.6)

PROBLEM 18
The current price of a company share is Rs. 75 and dividend per share is Rs.
5 calculate the dividend growth rate if its capitalization rate is 12%. (Sharma
Gupta Page No. 25.10 Problem No.7)
PROBLEM 19
The current price of a company share is Rs. 200. The company is expected
to pay a dividend of Rs. 5 per share next year with an annual growth rate of
10%.If an investors required rate of return is 12% should he buy the share?
(Sharma Gupta Page No. 25.10 Problem No.8)

Modigliani & Miller (M.M) Hypothesis : Irrelevance Theory

PROBLEM 20
ABC Ltd., has a capital of Rs. 10,00,000 in equity shares of Rs. 100
each. The share are currently quoted at par. The company proposes to
declare a dividend of Rs. 10 per share at the end of the current financial
year. The capitalization rate for the risk class to which the company belongs
is 12%.

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 Programme: MBA Semester-II (CBCS- OUTCOME BASED)
Course:- Financial Management
Module 5 : Dividend Policy

What will be the market price of the share at the end of the year, if

a) A dividend is not declared?

b) A dividend is declared?

Assuming that the company pays the d iv id e n d and has net profits
of Rs. 5,00,000 and makes new investments of Rs. 10,00,000 during the
period, how many new shares must be issued. Use the MM model. %.
(Rustagi Page No.307; Problem No.14.19)

PROBLEM 21
Textrol Ltd. has 80,000 shares outstanding. The current market price of
these shares is Rs. 15 each. The company expect a net profit of Rs.
2,40,000 during the year and it belongs to a risk-class for which is the
appropriate capitalization rate has been estimated to be 20%. The
Company is considering dividend of Rs. 2 per share for the current year.

a) What will be the price of the share at the end of the ye a r (i) if the
dividend is paid and (ii) if the dividend is not paid.

b) How many new shares must the Co. issue if the dividend is paid and
the Co. needs Rs. 5,60,000 for an approved investment expenditure
during the year? Use MM model for the calculation. (Rustagi Page No.307;
Problem No.14.20)

PROBLEM 22

Diamond engineering Company has 10,00,000 equity shares outstanding

at the start of the accounting year 1997. The ruling market price per share
is Rs. 150. The Board of Directors of the Company contemplates declaring
Rs. 8 per share as dividend at the end of the current year. The rate of
Capitalization appropriate to the risk-class to which the company belongs
is 12%.

a) Based on Modigliani-Miller Approach, calculate the market

price per share of the company when the contemplated dividend is
(i) declared and (ii) not declared.
b) How many new shares are to be issued by the company at the end
of the accounting year on the assumption that the Net Income for

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 Programme: MBA Semester-II (CBCS- OUTCOME BASED)
Course:- Financial Management
Module 5 : Dividend Policy

the year is Rs 2 crores. Investment budget is Rs. 4 corers and (i)

the above dividends are distributed and (ii) they are not
distributed.
c) Show that the total market value of the shares at the end of the
accounting year will remain the same whether dividends are
either distributed or not distributed. Also find out the current
market value of the firm under both situations. (Rustagi Page
No.310; Problem No.14.25)

PROBLEM 23
A company belongs to a risk-class for which the appropriate
capitalization 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 Rs. 2.5 lacs and a proposal for
making new investments of Rs. 5 lacs. Show that under the MM
assumptions, the payment of dividend does not affect the value of the firm.
(Rustagi Page No.310; Problem No.14.26)

PROBLEM 24
The Agro Chemicals Company belongs to a risk class for which the
appropriate capitalisation rate is 10%. It currently has 1,00,000 shares
selling at Rs. 100 each. The firm is contemplating the declaration of Rs.5
as dividend at the end of the current financial year, which has j u s t begun.
What will be the price of the share at the end of the year, if a dividend is not
declared? What will it be if it is? Answer these on the basis of Modigliani
and Mi l l er model and assume no taxes. (Rustagi Page No.306; Problem
No.14.17)

PROBLEM 25
XYZ Ltd. has 50,000 equity shares of Ks. 10 each outstanding on January
1. The shares are cu r r e nt ly being quoted at par in the market. The
company now intends to pay a dividend of Rs. 2 per share for the curr ent
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 Programme: MBA Semester-II (CBCS- OUTCOME BASED)
Course:- Financial Management
Module 5 : Dividend Policy

calendar year It belongs to a risk-class whose appropriate

capita liz ation rate is 15%. U s i n g Modighani-Miller and assuming no
taxes, ascertain the price of the company’s shares it is likely to prevail at the
end of the year i) when dividend is declared, and ( i i ) when no d i v idend is
declared. Also find out the number of new equity share that the company
must issue to meet its i n v e s t m e n t needs of Rs.2 lacs, assu ming a net
income of Rs.1.1 lacs and also assuming that the dividend is paid.
(Rustagi Page No.306; Problem No.14.18)

PROBLEM 26
The present share ca pital of A Ltd. consist of 1,000 shares selling
at Rs. 100 each. The company is contemplating a dividend of Rs. 10 per
share at the end of the current fina ncia l year. The company belongs to a
risk class for which appropriate capitalization rate is 20%. The company
expects to have a net income of Rs.25,000. What will be the price of the
s ha r e a t the end of the year i f ( i ) dividend is not declared, and (ii) a
dividend declared. Presuming that the company pays t h e d i v i dend and
has to make new investment of Rs.48,000 in the coming period, how many
new shares be issued to finance the i nv es t m en t program? You are
required to use the MM model for t h i s purpose. (Rustagi Page No.308;
Problem No.14.22)