Question 6
MM approach: value with a 75% payout or no dividend
18.75 marks
- Time to write
- About 38 minutes
From an older CBCS paper
Question
Question 6 · 18.75 marksQ6. Progressive corporation provides 25% returns to its shareholders. Its shares' current market price is Rs 80, with 1.25 crore shares outstanding. In the year, the firm is expected to earn Rs. 4 crores, while its investment requirement for the period is Rs. 6 crores. It has been distributing dividends at 75% of its earnings. Given its expansion requirement, it is exploring the preposition of skipping the year's dividend altogether, and mobilizing the remaining funds through an issue of fresh shares. Examine the firm's value (as per the MM Model)) when the firm (a) continues its policy of a 75% pay out (b) decided to skip the year's dividend.
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
- ExamineLook at it from each side, then give your conclusion.
What the paper leaves open
"Preposition" is read as proposition, as printed. 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 Dividend per share and year-end prices 4 marks 7 min
- 2 Funds to be raised and new shares in each case 6 marks 11 min
- 3 Value of the firm in each case 6 marks 11 min
- 4 Conclusion 2.8 marks 5 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
Short on time? End with step 4's one-line conclusion, whatever happens: never leave the figures without it.
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.
Inputs. ke = 25%; P0 = ₹80; n = 1.25 crore shares; earnings E = ₹4 crore; investment I = ₹6 crore. "Preposition" is read as proposition (paper note).
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).
(a) 75% payout. Dividend = 75% × 4 crore = ₹3 crore, i.e. ₹2.40 a share. P1 = 80 × 1.25 − 2.40 = ₹97.60. (b) Dividend skipped. P1 = 80 × 1.25 = ₹100.
| Particulars | (a) 75% payout | (b) Dividend skipped |
|---|---|---|
| Retained earnings (E − nD1) | 1,00,00,000 | 4,00,00,000 |
| Raised by new shares (balancing) | 5,00,00,000 | 2,00,00,000 |
| Investment | 6,00,00,000 | 6,00,00,000 |
| New shares (amount ÷ P1) | 5,12,295.08 | 2,00,000 |
- [(1,25,00,000 + 5,12,295.08) × 97.60 − 6,00,00,000 + 4,00,00,000] ÷ 1.25 = (127,00,00,000 − 2,00,00,000) ÷ 1.25 = ₹100,00,00,000.
- [(1,25,00,000 + 2,00,000) × 100 − 6,00,00,000 + 4,00,00,000] ÷ 1.25 = (127,00,00,000 − 2,00,00,000) ÷ 1.25 = ₹100,00,00,000.
The value is ₹100 crore (1.25 crore × ₹80) either way: under MM, skipping the dividend saves the need to issue extra shares, but shareholders lose the dividend; continuing it costs them the same amount through the lower year-end price. The dividend decision does not affect the firm's value.
Where the 18.75 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Dividend per share and year-end prices | 4 |
| 2 | Funds to be raised and new shares in each case | 6 |
| 3 | Value of the firm in each case | 6 |
| 4 | Conclusion | 2.75 |
| Total | 18.75 |
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