Question 5
Maintaining a stable dividend; Walter's model payouts and prices
18.75 marks
- Time to write
- About 38 minutes
From an older CBCS paper
Question
Question 5 · 18.75 marksHow can a stable dividend policy be maintained?
The information below is taken from RST Ltd's current annual report:
| Earning of the firm | Rs. 9, 00,000 |
| Equity shares (number) | 1, 50,000 |
| Return on the equity | 22.5% |
| Cost of equity | 15% |
Using the Walter Model, what should the dividend payout ratio be so as to keep the share price at Rs. 48? Also determine both the optimum dividend payout ratio and, at that optimum ratio, the market price of the share. Under this model, what will the maximum and minimum share price?
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
- How…?What…?Determine…4 asks, each with its own marks below. Answer all 4.
- 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
No mark is printed for the question; the paper asks for any four of six, equal marks. "What will the maximum and minimum share price" is kept as printed. Earnings per share are the earnings over the number of shares.
Write it in this order
- Read the data; note exactly what is asked 2 min
- 1 Maintaining a stable dividend policy 7 marks 13 min
- 2 Payout for a price 4 marks 7 min
- 3 Optimum payout and price 4 marks 7 min
- 4 Maximum and minimum prices 3.8 marks 7 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.
How a stable dividend policy can be maintained
Meaning. A stable dividend policy is one under which the company pays a regular, steady dividend that does not swing with every change in the year's earnings. Dividends are changed only when a change in earnings looks lasting. Many companies believe that such a policy maximises the market value of their shares, improves their image and makes it easier to raise funds for expansion.
Methods of maintaining stability
- Constant dividend per share. A fixed amount is paid every year irrespective of actual earnings, and raised only when higher earnings look sustainable. To keep it up in poor years the company creates a Dividend Equalisation Reserve, invested in marketable securities, out of surplus earnings of good years. It suits persons and institutions that depend on dividend income.
- Constant payout ratio. A fixed percentage of each year's net earnings is paid (for example, "up to 30% of profit after tax"). The dividend moves with earnings, so the payout is stable but the amount is not.
- Small constant dividend plus extra dividend. A low regular dividend is paid every year, which the firm can maintain even in bad years, with an extra dividend in good years. The extra is labelled as such, so shareholders do not treat it as permanent; it gives flexibility while keeping the regular dividend steady.
- Dividend based on long-term earnings. The dividend is fixed on a forecast of sustainable long-term earnings and raised gradually, only when earnings have risen to a substantially higher level.
Other aids to stability: paying interim dividends at regular intervals, issuing bonus shares in place of a cash increase when cash is short, and keeping enough liquid resources.
Walter's model: RST Ltd.
EPS (E) = 9,00,000 ÷ 1,50,000 = ₹6; r = 22.5%; ke = 15%. Walter's formula: P = [D + r(E − D) ÷ ke] ÷ ke.
Payout for a price of ₹48. 48 = [D + 0.225(6 − D) ÷ 0.15] ÷ 0.15, so 7.20 = D + 1.5(6 − D) = 9 − 0.5D, giving D = ₹3.60, a payout ratio of 3.60 ÷ 6 = 60%.
Check: [3.60 + 0.225 × 2.40 ÷ 0.15] ÷ 0.15 = (3.60 + 3.60) ÷ 0.15 = ₹48.
Optimum payout. Since r (22.5%) > ke (15%), the firm is a growth firm and its share price is highest when it retains everything: the optimum payout ratio is 0%. At that ratio P = (0.225 × 6 ÷ 0.15) ÷ 0.15 = 9 ÷ 0.15 = ₹60.
Maximum and minimum prices. Under Walter's model the price falls steadily as the payout rises, so:
- Maximum price ₹60, at 0% payout;
- Minimum price ₹40, at 100% payout: P = 6 ÷ 0.15 = ₹40.
Where the 18.75 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Maintaining a stable dividend policy | 7 |
| 2 | Payout for a price of ₹48 | 4 |
| 3 | Optimum payout and price | 4 |
| 4 | Maximum and minimum prices | 3.75 |
| Total | 18.75 |
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