Question 5
Postponing dividends for growth: Gordon valuation; dividend policy and shareholders' wealth
18.75 marks
- Time to write
- About 38 minutes
From an older CBCS paper
Question
Question 5 · 18.75 marksQ5. Glacier Corporation, a market leader in refrigeration products, has paid dividend consistently over the last several years The average growth rate of dividend has been 12%. Glacier Corporation's capitalisation rate is 16%.
In keeping with its developmental philosophy, Glacier Corporation acquired a technology for a new refrigerant which needed a huge investment, but which offered a market potential of growth of 14% in earnings, and in dividends as well.
The management decided to skip the dividend for the next three years However, it announced, as a step of good corporate governance and to give the investors reassurance, that the dividend would re-commence 4 years from now at Rs. 12 only and would grow faster, at 14% instead of 12%. Assuming Gordon Assumptions, what do you think would be the impact on the market price of Glacier Corporation's shares of the announcement of the new project and the resulting postponement of dividend?
Against this background, "Do you agree that dividend policy can be used for maximizing the wealth position of the equity holders" Explain, with reference to the determinant of the dividend policy.
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
- agreeA statement to judge: take a stand on it in your first line, and come back to it at the end.
- Assuming Gordon Assumptions, what do you…The paper fixes this: use it as given, and say so in your answer.
- determinantFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
- The current dividend is not given, so the price before the announcement cannot be found from it; the answer values the share on the announced dividends and states the comparison it can make.
- No mark is printed for the question; the paper asks for any four of six, equal marks.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 Gordon valuation of the announced dividends 6 marks 11 min
- 2 Impact on the price, with the threshold comparison 3 marks 5 min
- 3 Dividend policy and shareholders' wealth: relevance and irrelevance 5 marks 9 min
- 4 Determinants of dividend policy 4.8 marks 9 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Try it first. About 38 minutes for 18.75 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.
Part 1: effect of the announcement on the share price. Under Gordon's model the share price is the present value of the expected dividends; with dividends growing at a constant rate g from next year, P = D1 ÷ (ke − g), provided ke > g.
The announced dividends: nothing in years 1–3; ₹12 at the end of year 4, growing at 14% thereafter; ke = 16%.
- Price at the end of year 3 (when the dividend stream begins a year later): P3 = D4 ÷ (ke − g) = 12 ÷ (0.16 − 0.14) = ₹600.
- Price today: P0 = 600 × 0.641 (present value factor, 3 years at 16%) = ₹384.60 (₹384.39 with the unrounded factor).
Impact. The current dividend is not given (paper note), so the old price cannot be computed directly. Under the old policy (12% growth), P0 = D1 ÷ (0.16 − 0.12) = 25 × D1. The new policy gives a higher price than the old one as long as the dividend the company would otherwise have paid next year was below 384.60 ÷ 25 = ₹15.38. The postponement does not by itself lower the price: the market values the higher growth (14% against 12%) from reinvesting at a return above the capitalisation rate, and the loss of three years' dividends is offset by the larger dividends later.
Part 2: can dividend policy maximise shareholders' wealth? Partly, yes.
- The relevance view (Walter, Gordon) holds that dividends affect value: dividends convey information about the firm's profitability, and a firm with profitable investment opportunities (r > k) adds value by retaining earnings, while one without them (r < k) should distribute. Glacier's decision follows this logic: the new technology offers 14% growth, so retention raises value.
- The irrelevance view (MM) holds that, in perfect markets, value depends only on investment policy; but taxes, flotation costs and information effects mean dividends matter in practice.
Determinants to weigh: availability of funds and investment opportunities (here, the strongest reason to retain); cost of capital (retained earnings avoid flotation costs); capital structure; the effect on the share price; the industry trend and shareholders' expectations of regular income (hence Glacier's reassuring announcement); and legal constraints. A dividend policy chosen with these in mind, retaining when investments earn more than ke, can maximise shareholders' wealth.
Where the 18.75 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Gordon valuation of the announced dividends | 6 |
| 2 | Impact on the price, with the threshold comparison | 3 |
| 3 | Dividend policy and shareholders' wealth: relevance and irrelevance | 5 |
| 4 | Determinants of dividend policy | 4.75 |
| Total | 18.75 |
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