Dividend policy Problems -1

Problem 1
From the following information supplied to you, ascertain whether the firm’s
dividend payout ratio is optimal, according to Walter. The form has started a year
before, with equity capital of Tk. 20,00,000.

The firm is expected to maintain its current ratio of earnings on investment.

Required:
i.Is the firm’s payout ratio optimum?
ii.What should be the P/E ratio at which dividend payout ratio will have no effect
on the value of the share?
iii.Will your decision be changed if the P/E ratio is 8 instead of 12.5?

Ans: i. Workings: DPS= 1,50,000 ÷ 20,000 = Tk. 7.50; EPS =2,00,000÷20,000

=Tk.10 ; P/E ratio = 12.5 ; so Ke = 1÷12.50=0.08×100 =8%; r= 20,000÷ 2,00,000
× 100=10%

According to Walter model, as we can see that r>ke. This is a growth firm. The
firm should retain the earnings and the optimum dividend policy would be zero.

P = [(Dps ÷ ke) + {(r÷ke)× (Eps- Dps)}÷ ke]

= [7.5+(.10÷0.08)×(10-7.5)]÷.08 = 132.81
The firm’s D/P ratio is not optimal. At 75 per cent D/P ratio, the price per share is
Rs 132.81. The zero per cent D/P ratio would be optimum, as at this ratio the value
of the share would be maximum as shown in the following calculations:

P = [(Dps ÷ ke) + {(r÷ke)× (Eps- Dps)}÷ ke]

= [0+(.10÷0.08)×(10-0)]÷.08 = 156.25

ii. At P/E ratio of 10 times, D/P ratio would have no effect on the value of the share
because at this rate ; Ke = r.

iii. Yes, the decision would change if the P/E ratio is 8. This implies that Ke is 12.5
per cent. Since Ke > r, the 100 per cent dividend payout ratio would maximise the
value of the share: P = [10 + (0.10/0.125) × (Rs 10 – Rs 10)]/0.125 = Rs 80. At all
other D/P ratios, the value would be lower.

Problem 2 (HW)
A firm follows a dividend policy which can maximize the market value of the
firm as per Walter’s model. In the current year the firm reports net earnings of Tk.
5,00,000. It is estimated that the firm can earn Tk. 1,00,000 if the amounts are
retained. The investors have alternative investment opportunities that will yield
them 10%. The firm has 50,000 shares outstanding.
i.What should be the dividend payout ratio of the company if it wishes to maximize
the wealth of the shareholders?
ii.Will your decision change if the P/E ratio is 8 instead of 12.5?
Ans: i.Workings: r= 1,00,000÷ 5,00,000= 20% ; Eps= 5,00,000÷50,000= Tk.10;
ke= 10%= 0.10.
D/P ratio of the company should be zero because at this ratio, market price of the
share would be the maximum as shown by the following calculations:
P = [ Dps+ (r÷ke)× (Eps-Dps)]÷ ke = [0 + (0.20/0.10) × (Rs 10 – 0)]/0.10
= Rs 20/0.10 = Rs 200
ii. No, the decision would not change if the P/E ratio is 8. This implies that Ke is
12.5 per cent. Since r>Ke, the 0 per cent dividend payout ratio would maximize the
value of the share: P = [0 + (0.20/0.125) × (Rs 10 – Rs 0)]/0.125 = Rs 128.

Problem 3
A company belongs to a risk class for which the appropriate capitalization rate is
10%. It currently has outstanding 25,000 shares selling at Tk. 100 each. The firm
is contemplating the declaration of a dividend of Tk. 5 per share at the end of the
current financial year. The co. expects to have a net income of Tk. 2,50,000 and
has a proposal for making a new investment of Tk. 5,00,000.
Show that under MM assumptions, the payment of dividend does not affect the
value of the firm.

Value of the Firm, When Dividends Value of the Firm, When Dividends
Are Paid: Are Not Paid:
(i) Price per share at the end of year 1, i) Price per share at the end of year 1,
P0= (D1+P1)÷ (1+ke) P0= (D1+P1)÷ (1+ke)
100 = (5+P1) ÷ 1.10 100 = (0+P1) ÷ 1.10
110= 5+P1 110=P1
P1= 105 P1=110
(ii) Amount required to be raised from (ii) Amount required to be raised from
the issue of new shares, the issue of new shares,
ΠnP1 = I – (E – nD1) ΠnP1 = I – (E – nD1)
= Rs 5,00,000 – (Rs 2,50,000 – Rs = Rs 5,00,000 – (Rs 2,50,000) = Rs
1,25,000) = Rs 3,75,000 2,50,000
(iii) Number of additional shares to be (iii) Number of additional shares to be
issued, issued,
Π n = Rs 3,75,000/Rs 105 = 75,000/21 Π n = Rs 2,50,000/Rs 110 = 25,000/11
shares shares
(iv) Value of the firm, (iv) Value of the firm,
nP0 = [(n+ Πn) ×p1- I + E ]÷ (1+ke) nP0 = [(n+ Πn) ×p1- I + E ]÷ (1+ke)
= [25,000 + 75,000÷21]×105 – Rs = [25,000 + 25,000÷11]×110 – Rs
5,00,000 + Rs 2,50,000 = Rs 5,00,000 + Rs 2,50,000 = Rs
27,50,000/1.1 = Rs 25,00,000 27,50,000/1.1 = Rs 25,00,000
Thus, whether dividends are paid or not, value of the firm remains the same.
The above example clearly demonstrates that the shareholders are indifferent
between the retention of profits and the payment of dividend.

Problem 4
A Textile Company belongs to a risk class for which the appropriate P/E ratio is
10. It currently has 50,000 outstanding shares selling at Tk. 100 each. The firm is
contemplating the declaration of Tk. 8 dividend at the end of the current fiscal
year which has just started. Given the assumption of MM, answer the following
questions:

i.What will be the price of the share at the end of the year: (a) if dividend is not
declared, and (b) if it is declared?
ii.Assuming that the firm pays the dividend, has a net income of Tk.
5,00,000, and makes a new investment of Tk. 10,00,000during the
period, how many new shares must be issued?
iii.What will be the value of the firm: if (a) dividend is declared, and (b) if dividend
is not declared.
Ans: i.(a) Price, P1, when dividend is not declared
P0 = (D1 + P1)/(1 + Ke)
Rs 100 = 0 + P1/(1 + 0.10) = Rs 110 = P1

(b) When dividend is declared

Price, P0 = (D1 + P1)/(1 + Ke) = Rs 100 = (Rs 8 + P1)/0.10 = 102

(ii) (a) Amount required for new financing

= I – (E – nD1) = Rs 10,00,000 – (Rs 5,00,000 – Rs 4,00,000) = Rs 9,00,000
(b) New shares to be issued Πn = Rs 9,00,000/102

(iii) (a) Value of the firm (V) when dividend is declared V = [nD1 + (n + Πn)P1 – I
+ E – nD1] /(1 + Ke)
= [(Rs 4,00,000 + 102 (50,000 + (Rs 9,00,000/102)] – 10,00,000 + 5,00,000 –
4,00,000] /1.10
= Rs 55,00,000/1.10 = Rs 50,00,000.

(b) Value, when dividend is not declared

V = [(n +Π n)P1 – I + E] /(1 + Ke)
= [(50,000 + Rs 5,00,000/100) 110 – Rs 10,00,000 + Rs 5,00,000]/1.1
= [Rs 60,00,000 – Rs 10,00,000 + Rs 5,00,000]/1.10 = Rs 50,00,000
Problem 5
A company has outstanding 10 lakh shares. The company needs Tk. 5 crore to finance its
investments for which Tk. 1 crore is available out of profits. The market price of share at the
end of current year is expected to be Tk. 120. If the discount rate is 10%, determine the
present value of a share using the MM model.
Ans:
Value of the Firm, When Dividends Are Paid Value of the Firm, When Dividends Are Not
Paid
(i) Price per share at the end of year 1,
P0= (D1+P1)÷ (1+ke)
P0 = (0+120) ÷ 1.10
P0= 109

Problem 6
A company has a total investment of Tk. 5,00,000 in a business and 50,000 outstanding
shares at Tk. 10 per share. It earns a rate of 15% on its investment, and has a policy of
retaining 50% of the earnings. If the appropriate discount rate of the firm is 10%,
determine:
i.the price of its share using Gordon’s model;
ii.What shall happen to the price of the share if the company has a payout ratio of 80% or
20%?

Ans: i.Using Gordon's share valuation model, the price of the stock:

P=EPS∗(1−b) ÷ (ke - br)

where, P = Price per share, EPS = Earnings per share, r = Investment rate, Ke =
Cost of capital, b = Retention ratio = (1 - Payout ratio), g = br = Growth rate

Asset per share is $10 and it earns a rate of 15%.* The required rate of return is
10%. The payout ratio is 50%

Applying the formula to calculate the price of the stock:

P= [ (10×15%)×(1-0.50)]÷[0.10- (0.50×0.10)] =15

ii. If the payout ratio is 80%:

P= [ (10×15%)×(1-0.20)]÷ [0.10- (0.20×0.10)] =15

If the payout ratio is 20%:

P= [ (10×15%)×(1-0.80)]÷[0.10- (0.80×0.10)] = 15

Dividend policy problems 2

Problem 7
X and Y are two fast growing companies in the engineering industry. They are close
competitors and their asset composition, capital structure, and profitability records have
been very similar for several years. Their recent earnings per share, dividend per share
and share price history are as follows:

Year Company X Company Y

EPS(Tk. DPS(Tk.) Price EPS(Tk.) DPS(Tk.) Price
) range(Tk.) range(Tk.)
1 9.30 2.00 75-90 9.50 1.90 60-80
2 7.40 2.00 55-80 7.00 1.40 25-65
3 10.50 2.00 70-110 10.50 2.10 35-80
4 12.75 2.25 85-135 1225 2.45 80-120
5 20.00 2.25 135-200 20.25 4.05 110-225
6 16.00 2.50 150-190 17.00 3.40 140-180
7 19.00 2.50 155-210 20.00 4.00 130-190
Required:
1.Determine the D/P ratio and P/E ratio for both the companies for all the years.
2.Determine the average D/P ratio and P/E ratio for both the companies over the period 1
through 7.
3.The management of company Y is puzzled as to why their share prices are lower than
those of company X, in spite of the fact that profitability record of company Y is slightly
better( particularly of the past three years). As a financial manager, how would you explain
the situation?

Effect of issuing bonus shares

The declaration of the bonus share will increase the paid up share capital and reduce the
reserves and surplus (retained earnings).The total net worth is not affected by the bonus
issue. It is merely an accounting transfer from reserves and surplus to paid up capital.
Problem 8

ABC Ltd has a capital structure shown below:

Equity share capital (5,00,000 shares @ Tk 10 each 50,00,000

Pref. share capital (50,000, shares @ Tk 100 each 50,00,000

Share premium 50,00,000

R&s 80,00,000
2,30,00,000

How would the capital structure be affected if

the company splits its stock five for one?
Show the changed capital structure if the
company declares a bonus shares in the ratio
of one for five
(1:5) to ordinary shareholders when the issue
price per share is Tk. 100.
Solution Changed capital structure after share
split

Equity share capital (25,00,000 shares @ Tk 2per Tk.

share) 50,00,000
Pref. share capital (50,000 shares 2 Tk. 100 each) 50,00,000
Share premium 50,00,000
R&S 80,00,000
Net worth 2,30,00,000

Workings:
Bonus shares =5,00,000÷5 = 1,00,000 or (5,00,000×20% = 1,00,000)
Value of bonus shares = 1,00,000 x 100 = 1,00,00,000
Adjustment: From R & S Tk. 80,00,000; and from share premium

20,00,000 Changed capital structure afterbonus

issue

2,30,00,000