Question 4 OR (a)
Market value of the shares and the optimal payout under Walter
9 marks
- Time to write
- About 18 minutes
Question
Question 4 OR (a) · 9 marksDetermine the market value of the company's equity shares from the information below:
Earnings – ₹24,00,000 Dividend paid – ₹14,40,000 Number of shares outstanding – 4,80,000 Price-Earning ratio – 8 Rate of return on investment – 15%
Further, comment on whether the firm's existing dividend policy satisfies you. If it does not, determine, according to Walter's Model, the optimal dividend pay-out ratio.
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
- Determine…Comment…Two asks in one question: answer both.
- comment onThe comment carries marks too: say what the figures show, in two or three lines.
- DetermineFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
The cost of equity is not given. It is read as the reciprocal of the price-earning ratio, and the market value of the shares as earnings per share times the price-earning ratio.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 EPS, DPS and cost of equity 2 marks 4 min
- 2 Market value of the shares 2 marks 4 min
- 3 Comment on the present policy 2 marks 3 min
- 4 Walter's optimal payout and price 3 marks 5 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Try it first. About 18 minutes for 9 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.
Basic figures. EPS = 24,00,000 ÷ 4,80,000 = ₹5; DPS = 14,40,000 ÷ 4,80,000 = ₹3; present payout = 60%. The cost of equity is not given; it is read as the reciprocal of the P/E ratio, ke = 1 ÷ 8 = 12.5% (paper note).
Market value of the equity shares (paper note): market price = EPS × P/E = 5 × 8 = ₹40 a share; for all 4,80,000 shares, ₹1,92,00,000.
Is the present dividend policy satisfactory? No. The firm earns r = 15% on its investments, more than the 12.5% shareholders require (r > ke), so it is a growth firm: every rupee retained earns more inside the firm than shareholders could earn elsewhere. Paying out 60% therefore lowers the share price.
Walter's model: P = [D + (r ÷ ke)(E − D)] ÷ ke, with r ÷ ke = 0.15 ÷ 0.125 = 1.2.
| Payout | DPS (₹) | Price (₹) |
|---|---|---|
| Present, 60% | 3 | (3 + 1.2 × 2) ÷ 0.125 = 43.20 |
| Optimal, 0% | 0 | (0 + 1.2 × 5) ÷ 0.125 = 48.00 |
| 100% | 5 | 5 ÷ 0.125 = 40.00 |
The optimal payout ratio under Walter's model is 0%: retaining all earnings gives the highest price, ₹48 a share.
Where the 9 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | EPS, DPS and cost of equity | 2 |
| 2 | Market value of the shares | 2 |
| 3 | Comment on the present policy | 2 |
| 4 | Walter's optimal payout and price | 3 |
| Total | 9 |
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