Question 5 (b)
Walter's model: price, firm value, optimum and target payout
11 marks
- Time to write
- About 22 minutes
From an older CBCS paper
Question
Question 5 (b) · 11 marksThe information below, for the current year, about PQR Ltd. is available:
| Earnings of the Firm | ₹ 21,60,000 |
| No. of equity shares | 3,60,000 |
| Amount of dividend paid | ₹ 10,80,000 |
| Return on Investment | 22.5% |
| Cost of Equity | 15% |
Using Walter's Model, calculate the share's present price and the firm's value.
Is this payout ratio the optimum ? If not, what is the optimum payout ratio ? At that payout ratio, what is the firm's value ?
At what payout ratio will the firm's value be lowest ?
If the firm wants to keep its share price at ₹ 55, what should the payout ratio be ?
When will the firm be indifferent about paying a dividend ? 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
- Is…?What is the…?What…?5 asks, each with its own marks below. Answer all 5.
- calculateFormula first, then the working, then the answer with its unit (₹, %, units).
- should theEnd with a one-line decision that follows from your figures.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Present price and value 3 marks 5 min
- 2 Optimum payout and value at it 3 marks 5 min
- 3 Lowest value 2 marks 4 min
- 4 Payout for 2 marks 4 min
- 5 Indifference 1 mark 2 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; DPS = 10,80,000 ÷ 3,60,000 = ₹3 (payout 50%); r = 22.5%; ke = 15%.
Walter's formula: P = [D + r(E − D) ÷ ke] ÷ ke.
(i) Present price and value. P = [3 + 0.225 × (6 − 3) ÷ 0.15] ÷ 0.15 = (3 + 4.5) ÷ 0.15 = ₹50. Value of the firm = 50 × 3,60,000 = ₹1,80,00,000.
(ii) Optimum payout. No. With r (22.5%) above ke (15%) the firm is a growth firm and should retain its earnings: the optimum payout is 0%. Then P = (0.225 × 6 ÷ 0.15) ÷ 0.15 = ₹60, and the value of the firm = 60 × 3,60,000 = ₹2,16,00,000.
(iii) Lowest value. At a 100% payout: P = 6 ÷ 0.15 = ₹40; value = ₹1,44,00,000.
(iv) Payout for a price of ₹55. 55 × 0.15 = D + 1.5 × (6 − D), so 8.25 = 9 − 0.5D and D = ₹1.50: payout 25%.
(v) Indifference. The firm is indifferent to the payout when r = ke: the dividend policy then does not affect the value of the share. Here that would need ke to equal 22.5%, or r to fall to 15%.
Where the 11 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Present price and value | 3 |
| 2 | Optimum payout and value at it | 3 |
| 3 | Lowest value | 2 |
| 4 | Payout for ₹55 | 2 |
| 5 | Indifference | 1 |
| Total | 11 |
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