Question 4 (a)
Walter's model: price per share and the optimum payout
8 marks
- Time to write
- About 16 minutes
From an older CBCS paper
Question
Question 4 (a) · 8 marksAs per Walter's model, calculate the price per share:
| Earnings of the company | Rs. 18,00,000 |
| Dividends paid out | Rs. 10,80,000 |
| Ordinary shares outstanding (number) | 3,60,000 |
| Ratio of price to earning | 8.33 |
| Return on investment (rate) | 15% |
Are you satisfied with the firm's current dividend policy? If not, in this case, what should be optimal dividend pay-out ratio? 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
- Are you satisfied…?A yes-or-no question: answer it in your first line, then explain why.
- calculateFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
The capitalisation rate is the reciprocal of the price-earning ratio (8.33 → 12%).
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 EPS, DPS and ke 2 marks 4 min
- 2 Price at the current payout 3 marks 5 min
- 3 Assessment and optimum payout, with price 3 marks 5 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.
Data. EPS (E) = 18,00,000 ÷ 3,60,000 = ₹5; DPS (D) = 10,80,000 ÷ 3,60,000 = ₹3 (payout 60%); r = 15%; ke = 1 ÷ P/E ratio = 1 ÷ 8.33 = 12% (paper note).
Walter's formula: P = [D + r(E − D) ÷ ke] ÷ ke.
Price at the current policy: P = [3 + 0.15 × (5 − 3) ÷ 0.12] ÷ 0.12 = (3 + 2.50) ÷ 0.12 = ₹45.83.
Is the policy satisfactory? No. The firm earns 15% on retained funds while shareholders require only 12% (r > ke): it is a growth firm, and every rupee retained adds more value than it would as a dividend. Under Walter's model the share price is maximised by retaining all earnings: the optimum payout ratio is 0%.
Price at the optimum payout: P = [0 + 0.15 × 5 ÷ 0.12] ÷ 0.12 = 6.25 ÷ 0.12 = ₹52.08, against ₹45.83 at the present 60% payout.
Where the 8 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | EPS, DPS and ke | 2 |
| 2 | Price at the current payout | 3 |
| 3 | Assessment and optimum payout, with price | 3 |
| Total | 8 |
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