Question 4 (b)
Walter's model: payout for a target price, optimum payout, price range
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 4 (b) · 11 marksThe information below is taken from MNP Ltd.'s annual report for the current year:
| Earnings of firm | ₹ 21.6 lakh |
| Number of equity shares | 3,60,000 |
| Return on investment | 22.5% |
| Cost of Equity | 15% |
Using the Walter Model, what should the dividend payout ratio be so as to keep the share price at ₹ 42 ? Also determine both the optimum dividend payout ratio and, at that optimum ratio, the market price of shares. Under this model, what will the maximum and minimum share price ? 11
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
- What…?Determine…Two asks in one question: answer both.
- determineFormula first, then the working, then the answer with its unit (₹, %, units).
- should theEnd with a one-line decision that follows from your figures.
What the paper leaves open
"What will the maximum and minimum share price" is kept as printed. Earnings per share are the earnings over the number of shares.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 EPS and Walter's formula 2 marks 4 min
- 2 Payout for a price 4 marks 7 min
- 3 Optimum payout and price at it 3 marks 5 min
- 4 Maximum and minimum price 2 marks 4 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.
EPS = 21,60,000 ÷ 3,60,000 = ₹6 (paper note); r = 22.5%; ke = 15%.
Walter's formula: P = [D + r(E − D) ÷ ke] ÷ ke.
Payout for a price of ₹42. 42 = [D + 0.225 × (6 − D) ÷ 0.15] ÷ 0.15, so 6.30 = D + 1.5 × (6 − D) = 9 − 0.5D, which gives D = ₹5.40. Payout ratio = 5.40 ÷ 6 = 90%.
Optimum payout. Since r (22.5%) exceeds ke (15%), the firm is a growth firm: retaining earnings adds value, and the optimum payout is zero. Price at 0% payout: P = [0 + 0.225 × 6 ÷ 0.15] ÷ 0.15 = 9 ÷ 0.15 = ₹60.
Maximum and minimum price. For a growth firm the price falls steadily as the payout rises, so:
- maximum price ₹60, at a 0% payout;
- minimum price ₹40, at a 100% payout: P = [6 + 0] ÷ 0.15 = ₹40.
(The target price of ₹42 thus needs a high, 90%, payout, close to the minimum.)
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | EPS and Walter's formula | 2 |
| 2 | Payout for a price of ₹42 | 4 |
| 3 | Optimum payout and price at it | 3 |
| 4 | Maximum and minimum price | 2 |
| Total | 11 |
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