Question 5 OR (b)
MM approach: price, new shares and value of the firm
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 5 OR (b) · 11 marksA company has a capital of Rs. 100 lakhs, in shares of Rs. 100 each, which are now quoted in the market at par. It plans to declare a dividend of Rs. 6 per share at the close of the current financial year, a year which has just begun. For the company's risk class, the capitalization rate is 10%. Answer the following, applying the MM Approach:
- Calculate the share's price at the end of the year if:
The dividend is declared.
The dividend is not declared.
Assuming the company pays the dividend, earns a net income of Rs. 10 lakhs and makes a new investment of Rs. 20 lakhs during the year, calculate the number of shares to be issued.
Find out the firm's value if:
The dividend is declared.
The dividend is not declared.
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- Calculate…Find…Two asks in one question: answer both.
- Assuming the company pays the dividend,…The paper fixes this: use it as given, and say so in your answer.
- CalculateFormula first, then the working, then the answer with its unit (₹, %, units).
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 MM relations 1 mark 2 min
- 2 Year-end price with and without the dividend 3 marks 6 min
- 3 Funds to be raised and new shares 3 marks 5 min
- 4 Value of the firm in both cases 4 marks 7 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Try it first. About 22 minutes for 11 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Inputs. Shares n = 100 lakh ÷ ₹100 = 1,00,000; P0 = ₹100 (quoted at par); ke = 10%; D1 = ₹6; net income E = ₹10 lakh; investment I = ₹20 lakh.
MM relations. P1 = P0(1 + ke) − D1; new shares m = [I − (E − nD1)] ÷ P1; value of the firm nP0 = [(n + m)P1 − I + E] ÷ (1 + ke).
(i) Price at the end of the year
- Dividend declared: P1 = 100 × 1.10 − 6 = ₹104.
- Dividend not declared: P1 = 100 × 1.10 − 0 = ₹110.
(ii) New shares to be issued if the dividend is paid
| Particulars | ₹ |
|---|---|
| Net income (E) | 10,00,000 |
| Less: dividend (1,00,000 × ₹6) | 6,00,000 |
| Retained earnings | 4,00,000 |
| To be raised by new shares (balancing) | 16,00,000 |
| Investment (I) | 20,00,000 |
m = 16,00,000 ÷ 104 = 15,384.62 shares.
- Dividend declared: [(1,00,000 + 15,384.62) × 104 − 20,00,000 + 10,00,000] ÷ 1.10 = (1,20,00,000 − 10,00,000) ÷ 1.10 = ₹1,00,00,000.
- Dividend not declared: new shares = (20,00,000 − 10,00,000) ÷ 110 = 9,090.91, and [(1,00,000 + 9,090.91) × 110 − 20,00,000 + 10,00,000] ÷ 1.10 = (1,20,00,000 − 10,00,000) ÷ 1.10 = ₹1,00,00,000.
The value of the firm is the same, ₹1 crore (= 1,00,000 × ₹100), whether or not the dividend is declared: the dividend received is offset by the lower year-end price, as MM hold.
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | MM relations | 1 |
| 2 | Year-end price with and without the dividend | 3 |
| 3 | Funds to be raised and new shares | 3 |
| 4 | Value of the firm in both cases | 4 |
| Total | 11 |
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