Question 4 OR (a)
Walter's model: is the dividend policy optimal?
8 marks
- Time to write
- About 16 minutes
From an older CBCS paper
Question
Question 4 OR (a) · 8 marksFrom the information below, ascertain whether, as per Walter Model, the firm follows an optimal dividend policy?
| Total Earnings | Rs. 2,40,000/- |
| Equity shares, number (Rs. 100/- each) | 24,000 |
| Dividend paid | Rs. 1,80,000/- |
| Ratio of Price/Earnings | 12.5 |
The firm is expected to keep up its rate of return on fresh investment. Also find out the P/E ratio at which the dividend policy would not affect the share's value?
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
- Ascertain…?Find…?Two asks in one question: answer both.
- ascertainFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
The rate of return is earnings over equity capital (24,000 shares of Rs. 100); the capitalisation rate is the reciprocal of the P/E ratio.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 EPS, DPS, r and ke 2 marks 4 min
- 2 Price at the present payout 2 marks 4 min
- 3 Optimal policy and price 2 marks 3 min
- 4 P/E at which dividends do not matter 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.
Data (paper note). EPS (E) = 2,40,000 ÷ 24,000 = ₹10; DPS (D) = 1,80,000 ÷ 24,000 = ₹7.50 (payout 75%). Rate of return r = earnings ÷ equity capital = 2,40,000 ÷ 24,00,000 = 10%. Capitalisation rate ke = 1 ÷ P/E = 1 ÷ 12.5 = 8%.
Walter's formula: P = [D + r(E − D) ÷ ke] ÷ ke.
Price under the present policy: P = [7.50 + 0.10 × 2.50 ÷ 0.08] ÷ 0.08 = (7.50 + 3.125) ÷ 0.08 = ₹132.81.
Is the policy optimal? No. Since r (10%) > ke (8%), the firm is a growth firm: the price is maximised by retaining all earnings, so the optimum payout is 0%. At 0% payout, P = (0.10 × 10 ÷ 0.08) ÷ 0.08 = 12.5 ÷ 0.08 = ₹156.25. The present 75% payout lowers the share's value by ₹23.44.
P/E ratio at which dividend policy does not matter. Dividend policy is irrelevant when r = ke, i.e. ke = 10%, a P/E ratio of 1 ÷ 0.10 = 10. At that ratio the price is ₹100 whatever the payout (e.g. at 75%: [7.50 + 0.10 × 2.50 ÷ 0.10] ÷ 0.10 = ₹100).
Where the 8 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | EPS, DPS, r and ke | 2 |
| 2 | Price at the present payout | 2 |
| 3 | Optimal policy and price | 2 |
| 4 | P/E at which dividends do not matter | 2 |
| Total | 8 |
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