Question 4 (b)
Walter's model: market value and the optimum payout
8 marks
- Time to write
- About 16 minutes
From an older CBCS paper
Question
Question 4 (b) · 8 marksFrom the information below, determine the Market value of the company's equity shares:
Earnings of the Company ₹ 12,00,000
Dividend Paid ₹ 7,20,000
Number of Shares Outstanding ₹ 2,40,000
Price Earning Ratio 8
Rate of Return on Investment 16%
Is the firm's current dividend policy satisfactory to you ? If it is not, what should the optimum dividend payout ratio be ? Use Walter's model. 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
Read from the question
- Is…?Two asks in one question: answer both.
- Is the firm's…?A yes-or-no question: answer it in your first line, then explain why.
- 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
The ₹ sign before the number of shares outstanding is a slip: 2,40,000 is read as the number of shares. The market value is worked out per share as the price earning ratio times the earnings per share, and the total for all the shares is also shown. For Walter's model the cost of equity is taken as the reciprocal of the price earning ratio (1/8 = 12.5%).
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 EPS, DPS and the market value from the P/E ratio 2 marks 4 min
- 2 Cost of equity and Walter's price at the present payout 2 marks 4 min
- 3 Assessment of the present policy r against ke 2 marks 3 min
- 4 Optimum payout and the price at it 2 marks 3 min
- Check: arithmetic, units (₹, %), final answer underlined 1 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.
Per-share figures. EPS (E) = 12,00,000 ÷ 2,40,000 = ₹5; DPS (D) = 7,20,000 ÷ 2,40,000 = ₹3; present payout ratio = 3 ÷ 5 = 60%.
Market value of the equity shares. Market price = price earning ratio × EPS = 8 × 5 = ₹40 a share, so the equity shares of the company are worth 40 × 2,40,000 = ₹96,00,000.
Walter's model. P = [D + (r ÷ ke)(E − D)] ÷ ke. The cost of equity is the reciprocal of the price earning ratio: ke = 1 ÷ 8 = 12.5% (paper note); r = 16%.
Price at the present 60% payout: P = [3 + (0.16 ÷ 0.125)(5 − 3)] ÷ 0.125 = (3 + 2.56) ÷ 0.125 = ₹44.48.
Is the present policy satisfactory? No. The firm earns 16% on its investments, more than the 12.5% its shareholders require (r > ke): it is a growth firm. Every rupee it retains is worth more than a rupee paid out, so the share price rises with each cut in the payout and is highest when all the earnings are retained. The optimum dividend payout ratio is 0%.
Price at the optimum (D = 0): P = [0 + (0.16 ÷ 0.125)(5 − 0)] ÷ 0.125 = 6.40 ÷ 0.125 = ₹51.20.
| Payout | Market price per share (₹) | Value of 2,40,000 shares (₹) |
|---|---|---|
| Present market value (P/E 8 × EPS 5) | 40.00 | 96,00,000 |
| 60% (present policy), by Walter's model | 44.48 | 1,06,75,200 |
| 0% (optimum), by Walter's model | 51.20 | 1,22,88,000 |
By retaining all its earnings the firm can raise the price of its share to ₹51.20.
Where the 8 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | EPS, DPS and the market value from the P/E ratio | 2 |
| 2 | Cost of equity and Walter's price at the present payout | 2 |
| 3 | Assessment of the present policy (r against ke) | 2 |
| 4 | Optimum payout and the price at it | 2 |
| Total | 8 |
Report a problemopens an email to admin@getkunji.com with the question ID1251-Q4balready filled in.