Question 5
MM dividend irrelevance; why a stable dividend policy matters
18.75 marks
- Time to write
- About 38 minutes
From an older CBCS paper
Question
Question 5 · 18.75 marksRST Ltd. currently has 150 lakh equity shares outstanding, at a Current market price per share of Rs. 12. Its net income for the current year is Rs. 2.5 crore, and its investment budget is also Rs. 2.5 crore. The Cost of equity is 10%. The company plans to declare a dividend @ Rs. 1 per share. Assuming the MM Approach:
Calculate the market price per share if the dividend is declared, and if it is not.
Under each option, how many new equity shares are to be issued?
Show that the dividend decision leaves the total market value of shares remain unaffected.
Also explain how a Stable dividend policy is relevant.
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
- Calculate…How…?Show…4 asks, each with its own marks below. Answer all 4.
- Show thatThe result is given: the marks are for the steps that reach it.
- Assuming the MM ApproachThe paper fixes this: use it as given, and say so in your answer.
- CalculateFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
Net income equals the investment budget, so with no dividend no new shares are needed, and with the dividend the shares issued fund the dividend paid; the answer states this. 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 Prices with and without the dividend 4 marks 7 min
- 2 New shares under each option 4 marks 7 min
- 3 Value of the firm unaffected 5 marks 9 min
- 4 Relevance of a stable dividend policy 5.8 marks 11 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.
MM approach
Formulae. P0 = (D1 + P1) ÷ (1 + ke), so P1 = P0(1 + ke) − D1; new shares m = [I − (E − nD1)] ÷ P1. Here n = 150 lakh shares, P0 = ₹12, ke = 10%, E = ₹2.5 crore, I = ₹2.5 crore, D1 = ₹1.
(i) Market price per share at the year end
- Dividend declared: P1 = 12 × 1.10 − 1 = ₹12.20.
- Dividend not declared: P1 = 12 × 1.10 − 0 = ₹13.20.
(ii) New equity shares to be issued
| Particulars (₹) | Dividend declared |
|---|---|
| Net income (E) | 2,50,00,000 |
| Less: dividend (150 lakh × ₹1) | 1,50,00,000 |
| Retained earnings | 1,00,00,000 |
| Add: new issue needed (balancing figure) | 1,50,00,000 |
| Investment budget (I) | 2,50,00,000 |
- Dividend declared: m = 1,50,00,000 ÷ 12.20 = 12,29,508.20 shares (about 12.3 lakh).
- No dividend: retained earnings of ₹2.5 crore exactly fund the investment, so no new shares are needed.
As the paper note observes, net income equals the investment budget, so the new issue in the dividend case simply replaces the cash paid out as dividend.
(iii) Total market value is unaffected. Value now = [(n + m)P1 − I + E] ÷ (1 + ke):
| Particulars (₹) | Dividend declared | No dividend |
|---|---|---|
| Shares at the year end (lakh) | 162.30 | 150.00 |
| Price at the year end | 12.20 | 13.20 |
| Value of shares at the year end | 19,80,00,000 | 19,80,00,000 |
| Less: investment (I) | 2,50,00,000 | 2,50,00,000 |
| Add: net income (E) | 2,50,00,000 | 2,50,00,000 |
| Total, discounted at 1.10 | 18,00,00,000 | 18,00,00,000 |
Either way the firm is worth ₹18 crore today (= 150 lakh × ₹12), so the dividend decision does not affect the value of the firm, as MM hold.
Relevance of a stable dividend policy
MM's irrelevance rests on perfect markets, no taxes or flotation costs, and certainty. In practice a stable dividend matters:
- Investors who depend on dividend income (individuals and institutions meeting living and operating expenses) prefer a constant dividend.
- Information content: a steady dividend signals management's confidence in sustainable earnings, so a cut is read as bad news and depresses the price.
- Market value and image: investors pay more for shares with a regular dividend record; the firm finds it easier to raise funds later.
- Methods: a constant dividend per share supported by a dividend equalisation reserve, or a constant payout ratio.
So, although MM show that the payout does not affect value in theory, firms keep their dividends stable because real markets reward it.
Where the 18.75 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Prices with and without the dividend | 4 |
| 2 | New shares under each option | 4 |
| 3 | Value of the firm unaffected | 5 |
| 4 | Relevance of a stable dividend policy | 5.75 |
| Total | 18.75 |
Report a problemopens an email to admin@getkunji.com with the question IDFMP20-Q5already filled in.