ILLUSTRATIONS

TDestration: 1(Growth firm) -Walter Model

The cost ofcapital and the rate of return on investment of Rafael Ltd. are 10%
and 18% respectively. The company has 5lakh equity shares of Rs. 10each
outstanding and earnings per share are Rs. 20. Compute the market price per
share and value of fim in the following situations. Use Walter Model and comment
on the results.

) No retention, (ii) 40% retention, (ii) 80% retention.

Solution:
(i) 0% retention:100 %payout

Market price per share under Walter Model

D+(E-D)
D=Dividend per share = EPS x Payout
-20 x100%=Rs. 2 0 t i y t
r=Rate of return=18%
k=Cost of capital = 10%
E-Earnings per share = Rs. 20

20+| 0.181
0.10
(20-20)
.Market price per share
0.10

20
= Rs.200
0.10
Value of fim: No.of equityshares x Market price per share
=5,00,000 x 200
=Rs. 10,00,00,000
(ii) 40% retention; 60% payout
D=Dividend per share:20 x 60%= Rs.12
fo.181
12+
0.10
x(20-12)
:. Market price per share = 0.10

264
-= Rs.264
010
 8.14 Financial Management
Value offim:5,00,000shares x Rs. 264
- Rs. 13,20,00,000
(iii) 80% retention: 20% payout
D= Dividend per share= 20 x 20% = Rs. 4
4+ 0.187 -(e0-4)
: Market price per share 0.10
0.10
32.8
-=Rs. 328
0.10
Value of Fim:5,00,000shares x 3 2 8 e 0 0 o
=Rs. 16,40,00,000
Analysis: Rafeal Ltd is a growth firm (r> k). As payout increases, the value of
firm deereases. Ideal payout is 0%.
Ilustration: 2 (Normal firm)-Walter Model
capitalization
The earnings per share of Nadal Ltd. are Rs. 15 and the rate of
applicable to the company is 12%. The productivity of earnings (r) is12%.
Compute the market value of the company's share if the payout is (i) 20%;
(ii) 50% (iüi) 70%. Which is the optimum payout?
Solution:
Computation of market value per share
(i) Payout = 20%

-D+(E-D)
Market value per share =
k
D=Dividend pershare EPS x Payout ratio
=15x 20%=Rs. 3
r=Rate of return= 12%
k=Cost ofcapital = 12%
E-Earnings per share =Rs. 15
3+12k(s-3)
0.12
. Market value per share
0.12

15
Rs.125
0.12
(i) Payout 50%
D= Dividend per sharc = 15 x 50% = Rs. 7.50
Dividend Policy 8.15

0.12
Market value per share 750+x(15-750)
\0.12
0.12

15
-= Rs.125
0.12
(ii) Payout is 70%
D= Dividend per share = 15 x 70%=Rs. 10.5

: Market value per share =

10.5 +| (0.12)%(65-10.5)
0.12

15
-=Rs.125
0.12
Analysis :Nadal Ltd. is anormal firm (r=k). Market value per share remains
the same for all pay outs. Hence there is no optimum payout.
lysation: 3(Decliningfrm)-Walter Model
The earnings per share of WickMayer Ltd. are Rs. 12. The rate ofcapitalization
is 15% and the rate of return on investment is 9%.
Compute the market price per share using Walter's formula if the dividend
payout is (a) 25% (b) 50% and (°) 100%. Which is the ideal payout?
Solution :
() Computation of market price per share when payout is 25%

Market price per share D(6-0) k

D=Dividend per share = EPS x Payout ratio
=12x 25%= Rs. 3
r=Rate of return =9%
k=Cost of capital =15%
E=Earnings per share =Rs. 12
0.09
:. Market price per share
3+ 0.15) (12-3)
0.15

8.4
= Rs56
015
8.16 Financial Management
payout is 50%
(it) Computation of market price per share when
D=Dividend per share = 12 x 50%= Rs.6
0.09
6+ 0.15
1s(12-6)
. Market price per share 0.15

9.6
= Rs.64
0.15
when payout is 100%
(iii) Computation of marketprice per share
D=Dividend pershare =12 x 100%= Rs. 12
0.09
12+00x(12-12)
0.15)
:. Market price per share 0.15

12 = Rs.80
0.15
Analysis: WickMayer Ltd. is adeclining firm (r<k). Market price per share is
the highest when payout ratio is 100% Hence, the ideal payout ratio for the
compaay is 100%.
IJstration:4
Details regarding three companies are given below :
Nel Ltd. Mel Ltd. Gel Ltd.
r=18% e p=20% sYsp=8%o
k=15% Sk=20% k=10%
E-Rs. 30 E-Rs. 40 E=20
By using Walter's model, you are required to
) Calculate the value of an equity share of each of these companies when
dividend payout is (a) 30%, (b) 60%, (c) 100%;
) Comment on the results drawn.
Solution:
L Nel Lud
(a) Computation ofvalue ofan equityshare when payout is 30%

Value of an equity share D--E-D) k

D=Dividend per shareEPS x Payout ratio
=30x 30%=Rs. 9
 Dividend Policy 8.17
r=Rate of return = 18%
k=Cost of capital =15%
E- Earnings per share=Rs. 30
9+/018)
Value of an Equity share 0.15)x(30-9)
0.15

34.2
= Rs.228
0.15
(b) Computation of value of an equity share when payout is 60%
D=Dividend per share=30 x 60%=Rs. 18
0.18
Lo15) x(30-18)
18+|
. Value of an equity share
0.15

32.4
= Rs.216
0.15
100%
(c) Computation of value of anequity share when payout is
D=Dividend per share 30x 100%= Rs.30

30+
share\0.15/ng 30-30)
. Value of an equity
0.15

30
= Rs.200
0.15
If payout increases, share price
Analysis : Nel Ltd. is a growth firm (r> k). the firm So, the ideal payout is
profit with
declines. Itis better to retain the entire
0%.
IL Mel Ld. 30%
(a) Computation of value of anequity share when payout is

Value of an equity share

EPS x Payout ratio
D= Dividend per share =
= 40x 30%= Rs.12
r=Rate of return =20%
k=Cost of capital =20%
Rs. 40.
E= Earnings per share =
8.18 Financial Management
12+0(40-12)
.. Value of an equity share
0.20

40
0.20
Rs.200cbd ne to e
(b) Computation ofvalue of an equity share when payout is 60%
D=Dividend per share = 40 x 60%= Rs. 24

: Value of an equity share -

24+
0.20 40-24)
0.20
81-08)x 40 ouleY
200o
= Rs
0.20
(c) Computation of value of an equity share when payout is 100%
D=Dividend per share = 40 x 100%=Rs. 40
0.20
40+
0.20)
(40-40)
: Value of an equity share =
0.20
8L0
(0E-08)
40
= Rs.200
020
Analysis : Mel Ltd.is anormal firm (r=). Dividend payout does not atfect
the value of equity share of the firn.
II Gel Ltd
(4) Computation of value ofan equity share when payout is 30%

Value of an equity share = D-((E-D)

D= Dividend per share = EPS xPayout ratio
=20 x 30%= Rs. 6
r=Rate of return = 8%
k=Cost of capital 10%
E- Earnings per share: Rs. 20
Dividend Policy 8.19

0.08)
6+ (o1ox(20-6)
. Valueof an equity share
0.10

17.2
- Rs.172
0.10
(b) Computation of value of an equity share when payoutis 60%
D=Dividend per share = 20 x60%Rs. 12
0.08)
12+| 0.10/ x(20-12)
. Value of an equity share =
0.10

18.4
= Rs.184
0.10

(c) Computation of value of an equity share when payout is 100%

D=Dividend per share 20 x 100%=Rs.2 0 C
0.08)
20+
0.10
x(20-20)
Value of an equity share = 0.10

20
-=Rs.200
0.10
(r< k). If payout ratio increases, the
Analysis: Gel Ltd. is a declining firm the
equity increases. It is better to distribkte all the' profits to
value of an
payout is 100%.
shareholders of thefirm. Hence, the ideal
Illyaration: 5
Chetan Ltd. earns Rs. 50 per share. investment is 18%.
capitalisation rate is 15% and the return on
The
Under Walter's Model, determine
(a) the optimum payout
at this payout
(b) the market price of the share
share if payout is 40%
() the market price of the
share if payout is 80%.
() the market price of the
Solution:
increase with every increase in retention.
() Ifr>k, the value
of share will when the firm retains
all the
maximum
share would be zerofor Chetan
Ltd.
1he price of the ratio is
earnings. Thus, the optimum payout
payout
8.20 Financial Manageme
(b) Computation of market price of share ifpayout ratio is zero

Market price of share

Dl(8-D)
k
D=Dividend per share 50,x 0%=0
r=Rate of return= 18%
k=Cost of capital = 15%
E-EPS =Rs. 50

0+18 -(50-0)
share'(0.15
.. Market price of 0.15

60
Rs.400
0.15
(c) Computation ofmarket price of share ifpayout ratio is 40%
D=Dividend per share =50x 40% =Rs. 20
0.18
ssg:20+1x(50-20)
(015
. Market price of share 0.15

56
Rs373.33
0.15
80%
(d) Computation of market price of share ifpayout ratio is
D=Dividend per share =50 x 80%= Rs. 40
(0.18)
: Market price of share
40+1(S0-40)
0.15/
0.15
= Rs. 346.67 sey
Dividend Palicy 8.25
Ilustation: 8(Growth firm)-Gordon Model
The following data relates to Yanina Ltd.
Earnings per share Rs. 14
Capitalisation rate =15%
Rate of return=20%
Determine the market price per share under Gordon's
(a) 40% (b) 60%, (¢) 20%. model if retention is
Solution:
Computation of marketprice per share under Gordons Model
(a) Retention ratio = 40%
D
Market price per share
k-g
D-Dividend per share =EPS xPayout ratio
=14x 60% Rs. 8.40
k=Cost of capital =15%
g=Growth rate = Retention ratio (b)x Rate of return ()
= 40% x 20%
=0.4x 0.2 =0.08 x 100
oite o=8%
8.40
:. Market price per share
15% -8%
8.40
= Rs.120
7%
(b) fRetention ratio = 60%
D=Dividendper share =14x 40%-Rs. 5.6
g=Growth rate=bx r-60%x 20%
=0.6x 02-0.12x 100%=12%
5.6
. Market price per share =
15%-12%
5.6
Rs.186.67
3%
(c) If Retention ratio = 20%
D=Dividend per share =14 x 80%=Rs. 11.20
g=Growth rate=bx r=20%x 20%
=0.2 x 0.2 =0.04x 100
= 4%
 Financial Manayemem
11.20
.. Market price per share 15%-4%
11.20
Rs.101.82
11%
Analysis: Yanina Ltd is agrowth fim(r>).
Ilusation: 9(Normal firm)-Gordon Model
Du Preez Ltd. gives you the following information :
Earnings per share: Rs. 45
Cost of capital :18?%
Return on investment: 18%
Ascertain the market value per share using Gordon's Model, if the payout is
(a) 30%, (b) 60%, (c) 90%.
Solution:
Compulation of market value per share under Gordon 's Model
(a) Payout ratio = 30%: Retention ratio = 70%
D
Market value per share =
k-g
D=Dividend per share = EPS x Payout ratio
=45x.30% -Rs. 13.50
k=Cost of capital =18%
ggrowth rate = Retention ratio (b) ×Rate of return (r)
=70% x 18%
=0.7 x0.18=0.126x 100=12.6%
13.50
. Market value per share 18%-12.6%
. y
0t-13.50
=Rs. 250
5,40%:
(b) Payout ratio = 60%; Retention ratio = 40% 9ags n
D= Dividend per share. =45 x 60%= Rs. 27.
g=Growth rate=bxr =40%x 18%
=0.4x 0.18
-0.072 x 100 7.2%
27
.:. Market value per share
18%-72%
27
Rs250
10.8%
DividendPolicy 8.27
Payout ralio 90%: Retention ratio 10%
(c)
D= Dividend per share=45 x 90%=Rs, 40.50
growth rate =bx =10%x 18%
=0.1 x 0.18=0.018 x 100
1.8%
4050
. Market value per share = 18%-1.8%

4050
= Rs.250
16.2%
Analysis : Dui Preez Ltd is a normal firm (r=k). The share price 1remains the
ratios.
same for diterent payout
Ilustrnon: 10(Declining firm)-Gordon Mode!
Petkins Ltd. earns aprofit of Rs. 35per share. The rate of capitalisation is 15%
and the productivity of retained eamings is 10%. Using Gordon's model, determine
the market price per share if the payout is (a) 20%, (b) 40% and (c) 70%
Solution:
Computation of marketprice per share under Gordon s Model
(a) Payout ratio :20%: Retention ratio : 80%
D
Market price per share =
k-g
D=Dividend per shareEPS xPayout ratio
35x 20% = Rs. 7
k=Cost of çapital =15%
g=Growth rate Retention ratio (b) x Rate of return ()
80% 10%
=0.8 x 0.10=0.08 x 100=8%
7
:. Market price per share.
15%-8%
7
7%
-= Rsl00
(b) Payout ratio = 40%: Retention ratio = 60%
D=Dividend per share=35 x 40%=Rs. 14
g=Growth rate =bx r=60%x 10%
=0..6 x 0.10 =0.06 x 100
=6%
 8.28
14
Financial Managemt
14
. Market price per share
15%-6% 9%
Rs. 155.56
(c) Payout ratio =70% : Retention ratio = 30%
D=Dividend pershare =35 x70% =Rs. 24.5
g=Growth rate =bx r=30%x 10%
=0.3 x 0.10=0.03 x 100
-3%
24.5
Market price per share = 15%-3%
245
= Rs.204.17
12%
Anaysis: Perkins Ltd. is adeclining firm (r<h
Iptration: 11(Changes in cost of capita)-Gordon Model
The following data relates to Bailey Ltd.
Rate of return= 12%
Earnings per share Rs. 60
Find out the market price per share in the following cases, using Gordon'
Model:
Dividend payout Retention.Cost of capital
20%
50. 15%
() 50
() 0 ÜS 20 10%
Solution:
Computation of marketprice per share under Gordon's Model
() Payot ratio : 25%; Retention ratio: 75%; Cost of capital: 20%
D
Market price per share=
D=Dividend per share =EPS Payout ratio
=60 x 25%= Rs. 15
k= Cost of capital =20%
g=Growth rate Retention ratio (6) xRate of return ()
75% x12%
-(0.75x0.12) 100= 08%
15
. Market price per share = 20%-9%
15
11%-Rs. 136.36.
Dividend Policy
8.29
(i) Payout ratio : 50%; Retention ratio: 50%; Cost
of capital : 15%
D= Dividend per share 60 x 50%= Rs. 30
k=Cost of capital =15%
g=Growth rate =bx r =50%x 12%
=(0.5 x 0.12) x 100 =6%
30
Market price per share
15%-6%
30
= Rs.333.33
9%
(ii) Payout ratio: 80%; Retention ratio: 20%; Cost of capital:
10%
D=Dividend per share 60x 80%=Rs. 48
k=Cost of capital =10%
g=Growth rate =bxr =20% x12%
F(9.2x 0.12) x 100=2.4%
48 .
:. Market price per share
10% -2.4%
48
7.6%
Istration: 12 (Walter &Gordon Models)
Calculate the market price ofa share ofPollard Lid. under :(a) Walter's fomula,
and (b) Dividend Growth model from the following data :
Earnings per share Rs. 75
Dividend per share Rs. 45
Cost of capital
Räte of return on investrhent 18%g.

Retention ratio 40%

s (a) Computation of market price per. share under Walter sModel

a o Market price per share =

D+E-D)
D= Dividnd per share=Rs. 45
r=Rate of return =18%
k=Cost of capital =15%
E=Earnings per share =75
 8.30 Financial Managemem
454s0.18
+ s-4s)
(75-4s)
0.15
. Market price per share = 0.15

81
Rs.540
0.15
(b) Computation of market price per share under dividend growih
(Gordon) Model
D
Market price per share t-g
D= Dividend per share Rs. 45
k=Cost of capital =15%
g=Growth rate = Retention ratio (b) x Rate ofreturn (r)
=40% x 18%=(0.4x 0.18) x 100=7.2%
45
.. Market price per share = 15%-7.2%googohsl
45
= Rs.576,92
7.8%
llpeation: 13 (MM Model)
market price of these
Stewart Ltd, has 40,000 _hares outstanding. The current
company has recommended
shares is Rs. 15 cach. The Board of directors of the risk-clas
Rs. 2per share as dividend. The rate ofcapitalisation appropriate to the
to which the company. belongs is 20%.
market price oftheshare of the
) Based.on MM approach, calculate the, distributed and (b) not
company when the recomimended dividendis (a)
declared.
the oompany at the end of the
(1) How many new shares to be issued by net income for the yea
accounting year on the assumption that the
2;80,000 when (a) the
is Rs. 1,20,000 and the investment budget is Rs. are. not declared.
above dividends are distributed and (b) diidends accounting yea
the end of the
(1) Show that market value of the shares at distributed or not declarea
are
will remain the same whether ividends
mar its validity?
(v) Is the MM approach realistic? What factors might
Solution :
Compuiation of marketprice of the share nder MM model
(a) Ifdividends are distributed
Market price of share (P) =P, x(1+k,)-D,
 Dividend Policy 8.31

P,=Current market price= Rs. 15

k, =Cost of equity =20%
D,=Dividend= Rs. 2
. Market price per share (P) -15x (1 +0.20)-2
=15x (1.20)-2
=18-2= Rs. 16
(b) If dividends are not declared
D =Dividend =0
. Market price per share=15 x(1 +0.20)-0
=15 x(1.20)-0
-Rs. 18
(i) Computation of no.ofshares to be issued tofinance the investment proposal
(a) fdividends are distributed
Rs. Rs.
Investment proposed 2,80,000
Less:Retained earnings available
for investment: eookislol
Net income 81 1,20,000
Less: Dividends distributed
(40,000 x 2) 80,000 40,000

Funds to be raised by issue of shares 2,40,000

o Market price (ifdividend is declared) 16

2,40,000
. No.of new shares to be issued =
16
=15,000 shares
(b) fdividends are not declared
Rs.
Investment proposed 2,80,000
Less: Retained earmings
available for investment :
Net inconme 1,20,000
Less: Dividends distributed Nil 1.20,000

Funds to be raised by issue of shares 1,60,000

16
 8.32
Market price per share (Dividend
Financial Managgmeh
not declared)
Rs. 18
.. No.of shares to be issued 1,60,000
18
-8,889 shares
(i) Computation of market value of shares
(a) fDividends are distributed
No.of existing shares 40,000Sode
Add : New shares 15,000y6
Total No. of shares 55.000iBc
. Market value of shares = Total No. of shares x Market price per share
=55,000 x16
= Rs. 8,80,000
(b) fDividends are not declared
No. of existing shares 40,0002sbliso
Add: New shares 8,889

Total No. of shares 48,889 seniss

. Market value of shares = Total No. of shares x Market price per share
= 48,889 x 18
= Rs. 8,80,000
Analysis: From the above calculations, it is evident that the market value of
shares remains the same whether dividends are distributed or not declared.
(iy) The MM approach is unrealistic. ts validity is marred by realisti:
assumptions such as
(a) No corporate taxes
(b) No floatation andtransaction costs
(C) No difference in the tax rates applicable to dividends and capital gains