Question 4 OR (b)
Walter model: optimum payout and share prices
12 marks
- Time to write
- About 24 minutes
Question
Question 4 OR (b) · 12 marksThe following information has been collected from the Orion Ltd:
| Number of equity shares | Rs. 7,20,000 |
| Earning of Firm | Rs. 43,20,000 |
| Return of Investment | 22.5% |
| Cost of Equity | 15% |
Using these figures, as per the Walter model, (i) What would the optimum dividend payout ratio be? Determine the market price of shares when the (ii) Dividend payout ratio is nil and (iii) Dividend payout ratio is 100%. And (iv) What would the dividend payout ratio be, if share price is Rs. 50.
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
- What…?Determine…Two asks in one question: answer both.
- DetermineFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
"Number of equity shares" is printed with "Rs." and is read as a number of shares. "Return of Investment" is read as return on investment.
Write it in this order
A step that gives the answer away stays hidden: tap it to see it.
- Read the data; note exactly what is asked 2 min
- 1 (i) Optimum payout 3 marks 5 min
- 2 (ii) Price at nil payout 3 marks 5 min
- 3 (iii) Price at 100% payout 3 marks 5 min
- 4 (iv) Payout for a price 3 marks 5 min
- Check: arithmetic, units (₹, %), final answer underlined 2 min
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.
EPS = ₹43,20,000 ÷ 7,20,000 shares = ₹6; r = 22.5%; ke = 15%. Walter's formula: P = [D + (r ÷ ke)(E − D)] ÷ ke, with r ÷ ke = 0.225 ÷ 0.15 = 1.5.
(i) Optimum payout ratio. Since r (22.5%) > ke (15%), the firm is a growth firm: retained earnings earn more than shareholders require, so the optimum payout is zero (retain everything).
(ii) Price at nil payout (D = 0): P = [0 + 1.5 × 6] ÷ 0.15 = 9 ÷ 0.15 = ₹60.
(iii) Price at 100% payout (D = 6): P = [6 + 1.5 × 0] ÷ 0.15 = 6 ÷ 0.15 = ₹40.
(iv) Payout for a price of ₹50: 50 = [D + 1.5(6 − D)] ÷ 0.15, so 7.5 = D + 9 − 1.5D, so 0.5D = 1.5 and D = ₹3. Payout ratio = 3 ÷ 6 = 50%. Check: [3 + 1.5 × 3] ÷ 0.15 = 7.5 ÷ 0.15 = ₹50.
The price falls from ₹60 to ₹40 as the payout rises from nil to 100%, confirming that a growth firm maximises its share price by retaining earnings.
Where the 12 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | (i) Optimum payout | 3 |
| 2 | (ii) Price at nil payout | 3 |
| 3 | (iii) Price at 100% payout | 3 |
| 4 | (iv) Payout for a ₹50 price | 3 |
| Total | 12 |
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