Question 4 (b)

MM: share price, new shares and value of the firm

12 marks

Time to write: About 24 minutes
Topic: Dividend theories and dividend policy

Question

Question 4 (b) · 12 marks

Ganga Ltd. has 60,000 equity shares of Rs. 100 each, currently quoted at par in the market. It proposes to pay a dividend of Rs. 7 per share at the end of the current financial year. It belongs to a risk class with an estimated capitalisation rate of 15%. Using MM model.

Find the price of the company's share at the close of the year, if dividend is paid and if it is not is not paid.
Also find how many shares must be issued if company needs Rs. 7,20,000 and it expect to make net income of Rs. 4,92,000, both when dividend is paid and when it is not paid.
Using the information given above about Ganga Ltd., prove that its dividend decision of the firm does not affect the value of the firm.

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

24 minfor 12 marks

Read from the question

Find…Two asks in one question: answer both.
prove thatThe result is given: the marks are for the steps that reach it.
estimatedFormula first, then the working, then the answer with its unit (₹, %, units).

What the paper leaves open

"When it is not is not paid", "it expect" and the fragment "Using MM model." are printed so and kept.

Write it in this order

Read the data; note exactly what is asked 2 min
1 (i) Year-end price in both cases 3 marks 5 min
2 (ii) New shares to be issued in both cases 4 marks 7 min
3 (iii) Value of the firm in both cases; conclusion 5 marks 8 min
Check: arithmetic, units (₹, %), final answer underlined 2 min

123

Short on time? End with step 3's one-line conclusion, whatever happens: never leave the figures without it.

Try it first. About 24 minutes for 12 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 formulas: P1 = P0(1 + ke) − D1; m = [I − (E − nD1)] ÷ P1; nP0 = [(n + m)P1 − (I − E)] ÷ (1 + ke).

Here n = 60,000 shares, P0 = ₹100, ke = 15%, D1 = ₹7, I = ₹7,20,000 and E = ₹4,92,000.

(i) Price at the end of the year

Dividend paid: P1 = 100 × 1.15 − 7 = ₹108.
Dividend not paid: P1 = 100 × 1.15 − 0 = ₹115.

(ii) New shares to be issued

₹	Dividend not paid	Dividend paid
Net income available (E)	4,92,000	4,92,000
New equity to be raised	2,28,000	6,48,000
Funds needed: investment + dividend (I + nD1)	7,20,000	11,40,000
Price per new share (P1)	115	108
Number of new shares (m)	1,982.61	6,000

(iii) Value of the firm

Dividend not paid: [(60,000 + 1,982.61) × 115 − (7,20,000 − 4,92,000)] ÷ 1.15 = (71,28,000 − 2,28,000) ÷ 1.15 = ₹60,00,000.
Dividend paid: [(60,000 + 6,000) × 108 − 2,28,000] ÷ 1.15 = (71,28,000 − 2,28,000) ÷ 1.15 = ₹60,00,000.

The value of Ganga Ltd. is ₹60,00,000 (= 60,000 × ₹100) whether or not the dividend is paid, so its dividend decision does not affect the value of the firm: the dividend is offset by the lower year-end price and the extra shares issued.

Where the 12 marks sit

#	Component	Marks
1	(i) Year-end price in both cases	3
2	(ii) New shares to be issued in both cases	4
3	(iii) Value of the firm in both cases; conclusion	5
	Total	12

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