Question 4 (b)

Walter's model: is a 60% payout optimal?

7 marks

Time to write
About 14 minutes

From an older CBCS paper

Question

Question 4 (b) · 7 marks
  1. A company's total investment is ₹12,00,000, and it has 1,20,000 outstanding shares of face value ₹10 each. It earns 11% on its investment, and its policy is to pay 60% of its earnings as dividend. As per Walter's model, is it optimum dividend policy? What is the optimum policy, and why? Assume a required rate of return of 12%. Show the working.

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

14 minfor 7 marks

Read from the question

  • Is…?What is the…?Show…3 questions in all: answer every one. Where it asks why, give reasons, not a description.
  • Assume a required rate of return…The paper fixes this: use it as given, and say so in your answer.

What the paper leaves open

The rate of return is on the investment; the earnings per share are the return per share.

Write it in this order

  1. Read the data; note exactly what is asked 1 min
  2. 1 EPS and DPS 1½ marks 3 min
  3. 2 Price at the present payout 2 marks 3 min
  4. 3 Optimum policy with reason 2 marks 3 min
  5. 4 Price at the optimum 1½ marks 3 min
  6. Check: arithmetic, units (₹, %), final answer underlined 1 min

Try it first. About 14 minutes for 7 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) = 11% × 12,00,000 ÷ 1,20,000 = ₹1.10; dividend at 60% payout (D) = ₹0.66; r = 11%; ke = 12%.

Walter's formula: P = [D + r(E − D) ÷ ke] ÷ ke.

Price at the present 60% payout: P = [0.66 + 0.11 × (1.10 − 0.66) ÷ 0.12] ÷ 0.12 = (0.66 + 0.4033) ÷ 0.12 = ₹8.86.

Is it the optimum? No. The firm earns less on its investments (11%) than its shareholders require (12%): r < ke, a declining firm. Each rupee retained is worth less than a rupee paid out, so the share price is highest when all the earnings are distributed: the optimum payout is 100%.

Price at the optimum payout: P = [1.10 + 0] ÷ 0.12 = ₹9.17, against ₹8.86 at 60%.

Where the 7 marks sit

#ComponentMarks
1EPS and DPS1.5
2Price at the present payout2
3Optimum policy with reason2
4Price at the optimum1.5
Total7
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