Question 4 (b)

Walter's model: optimum payout and prices

8 marks

Time to write
About 16 minutes

From an older CBCS paper

Question

Question 4 (b) · 8 marks

A company's earning per share is Rs. 20, and the share's face value is Rs. 100. The company's rate of return is 25%, and the capitalization rate of its risk class 12.5%. If Walter's model is used:

  1. What should the optimum payout ratio be?

  2. At the optimum payout ratio, what should the market price per share be?

  3. What would the price per share be if company has a D/P ratio of 25%? 8

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

16 minfor 8 marks

Read from the question

  • What…?Two asks in one question: answer both.
  • should theEnd with a one-line decision that follows from your figures.

What the paper leaves open

"D/P ratio" is read as the dividend payout ratio.

Write it in this order

  1. Read the data; note exactly what is asked 1 min
  2. 1 Optimum payout, with reason 3 marks 5 min
  3. 2 Price at the optimum payout 2½ marks 4 min
  4. 3 Price at a 25% payout 2½ marks 4 min
  5. Check: arithmetic, units (₹, %), final answer underlined 2 min

Try it first. About 16 minutes for 8 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 = ₹20; r = 25%; ke = 12.5%. Walter's formula: P = [D + r(E − D) ÷ ke] ÷ ke.

(i) Optimum payout ratio: 0%. The firm earns more on its investments (25%) than its shareholders require (12.5%), so it is a growth firm: retaining earnings adds value, and the optimum payout is zero.

(ii) Price at the optimum payout. P = [0 + 0.25 × 20 ÷ 0.125] ÷ 0.125 = 40 ÷ 0.125 = ₹320.

(iii) Price at a 25% payout ("D/P ratio" read as the dividend payout ratio; paper note). D = 25% × 20 = ₹5: P = [5 + 0.25 × (20 − 5) ÷ 0.125] ÷ 0.125 = (5 + 30) ÷ 0.125 = ₹280.

Paying out a quarter of the earnings lowers the price by ₹40, as Walter's model predicts for a growth firm.

Where the 8 marks sit

#ComponentMarks
1Optimum payout, with reason3
2Price at the optimum payout2.5
3Price at a 25% payout2.5
Total8
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