Limitations of Stock Splits

1. Additional expenditure needs to be incurred on the process of stock split.

2. Low share price may attract speculators or short term investors, which are generally not
preferred by any company.

Practical Problems
Q1. M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has 25,000
outstanding shares and the current market price is Rs.100. It expects a net profit of
Rs.2,50,000 for the year and the Board is considering dividend of Rs.5 per share.

M Ltd. requires to raise Rs.5,00,000 for an approved investment expenditure. ILLUSTRATE,

how the MM approach affects the value of M Ltd. if dividends are paid or not paid.

Ans1. Given,

Cost of Equity ( 10%

Number of shares in the beginning (n) 25,000
Current Market Price ( ) Rs.100
Net Profit (E) Rs.2,50,000
Expected Dividend ( ) Rs.5 per share
Investment (I) Rs.5,00,000

Case 1 - When dividends are paid Case 2 - When dividends are not paid
Step 1 Step 1

= =

100 = 100 =

= 110 – 5 = 105 = 110 – 0 = 100

Step 2 Step 2
Calculation of funds required Calculation of funds required
= [Total Investment – (Net profit - Dividend)] = [Total Investment – (Net profit - Dividend)]
= 5,00,000 - (2,50,000 - 1,25,000) = 5,00,000 - (2,50,000 - 0)
= 3,75,000 = 2,50,000
Step 3 Step 3
No. of shares required to be issued for balance No. of shares required to be issued for balance fund
fund No. of shares =
No. of shares =
Δn =

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Δn =
= 2,272.73
= 3,571.4285
Step 4 Step 4
Calculation of value of firm Calculation of value of firm

Vf = Vf =

Vf = Vf =

= Rs.25,00,000 = Rs.25,00,000

Q2. The following information is supplied to you:

Rs.
Total Earnings 2,00,000
No. of equity shares (of Rs.100 each) 20,000
Dividend paid 1,50,000
Price/ Earnings ratio 12.5
Applying Walter’s Model:

(i) ANALYSE whether the company is following an optimal dividend policy.

(ii) COMPUTE P/E ratio at which the dividend policy will have no effect on the value of the
share.

(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5? ANALYSE.

Ans2. (i) The EPS of the firm is Rs.10 (i.e., Rs.2,00,000/ 20,000), r = Rs.2,00,000/ (20,000
shares × Rs.100) = 10%. The P/E Ratio is given at 12.5 and the cost of capital ( ) may be
taken at the inverse of P/E ratio. Therefore, is 8 (i.e., 1/12.5).

The firm is distributing total dividends of Rs.1,50,000 among 20,000 shares, giving a
dividend per share of Rs.7.50. the value of the share as per Walter’s model may be found as
follows:

P= =P= = Rs.132.81

The firm has a dividend pay-out of 75% (i.e., Rs.1,50,000) out of total earnings of
Rs.2,00,000. Since, the rate of return of the firm (r) is 10% and it is more than the of 8%,
therefore, by distributing 75% of earnings, the firm is not following an optimal dividend

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policy. The optimal dividend policy for the firm would be to pay zero dividend and in such a
situation, the market price would be:

= = Rs.156.25

So, theoretically the market price of the share can be increased by adopting a zero payout.

(ii) The P/E ratio at which the dividend policy will have no effect on the value of the share is
such at which the would be equal to the rate of return (r) of the firm. The would be
10% (= r) at the P/E ratio of 10. Therefore, at the P/E ratio of 10, the dividend policy would
have no effect on the value of the share.

(iii) If the P/E is 8 instead of 12.5, then the which is the inverse of P/E ratio, would be
12.5 and in such a situation > r and the market price, as per Walter’s model would be:

P= =P= = Rs.76

Q3. With the help of following figures CALCULATE the market price of a share of a
company by using:

(i) Walter’s formula

(ii) Dividend growth model (Gordon’s formula)

Earnings per share (EPS) Rs.10

Dividend per share (DPS) Rs.6
Cost of capital (Ke) 20%
Internal rate of return on investment 25%
Retention Ratio 40%

Ans3. Market price per share by

(i) Walter’s model

P= = = Rs.55

(ii) Gordon’s model

Present market price per share =

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= = Rs.60

Q4. The annual report of XYZ Ltd. provides the following information:

Particulars Amount (Rs.)

Net Profit 50 lakhs
Outstanding 15% preference shares 100 lakhs
No. of equity shares 5 lakhs
Return on Investment 20%
Cost of capital i.e. ( ) 16%
CALCULATE price per share using Gordon’s Model when dividend pay-out is:

(i) 25%;

(ii) 50%;

(iii) 100%.

Ans4. Price per share according to Gordon’s Model is calculated as follows:

Particulars Amount in Rs.

Net Profit 50 lakhs
Less: Preference dividend 15 lakhs
Earnings for equity shareholders 35 lakhs
Earnings per share 35 lakhs/5 lakhs = Rs.7.00

Price per share according to Gordon’s Model is calculated as follows:

Here, = 7, = 16%

(i) When dividend pay-out is 25%

= = = Rs.175

(ii) When dividend pay-out is 50%

= = = Rs.58.33

(iii) When dividend pay-out is 100%

= = = Rs.43.75

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Q5. A&R Ltd. is a large-cap multinational company listed in BSE in India with a face value
of Rs.100 per share. The company is expected to grow @ 15% p.a. for next four years then
5% for an indefinite period. The shareholders expect 20% return on their share
investments. Company paid Rs.120 as dividend per share for the current Financial Year.
The shares of the company traded at an average price of Rs.3,122 on last day. FIND out
the intrinsic value per share and state whether shares are overpriced or underpriced.

Ans5. As per Dividend discount model, the price of share is calculated as follows:

P= + +

Where,

P = Price per share

= Required rate of return on equity

g = Growth rate

P= + +

P= 115 + 110.2 + 105.6 + 101.2 + 590.42 = Rs.1,022.42

Intrinsic value of share is Rs.1,022.42 as compared to latest market price of Rs.3,122.

Market price of a share is overpriced by Rs.2,099.58 .

Q6. In the month of May of the current Financial Year, shares of RT Ltd. was sold for
Rs.1,460 per share. A long term earnings growth rate of 7.5% is anticipated. RT Ltd. is
expected to pay dividend of Rs.20 per share.

(i) CALCULATE rate of return an investor can expect to earn assuming that dividends are
expected to grow along with earnings at 7.5% per year in perpetuity?

(ii) It is expected that RT Ltd. will earn about 10% on retained earnings and shall retain
60% of earnings. In this case, STATE whether, there would be any change in growth rate
and cost of Equity?

Ans6. (i) According to Dividend Discount Model approach, the firm’s expected or required
return on equity is computed as follows:

= +g

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 = + 7.5%

= 0.0147 +0.075 = 0.0897 or 8.97%

(ii) With rate of return on retained earnings (r) is 10% and retention ratio (b) is 60%, new
growth rate will be as follows:

g = br = 0.10 × 0.60 = 0.06

Accordingly, dividend will also get changed and to calculate this, first we shall calculate
previous retention ratio (b1) and then EPS assuming that rate of return on retained earnings
(r) is same.

With previous Growth Rate of 7.5% and r =10%, the retention ratio comes out to be:

0.075 = × 0.10

= 0.75 and pay-out ratio = 0.25

With 0.25 pay-out ratio the EPS will be as follows:

= Rs.80

With new 0.40 (1 – 0.60) payout ratio, the new dividend will be

D1 = Rs.80 × 0.40 = Rs.32

Accordingly, new will be

= + 6.0%

Or, = 8.19%

Q7. Aakash Ltd. has 10 lakh equity shares outstanding at the start of the accounting year.
The existing market price per share is ₹ 150. Expected dividend is ₹ 8 per share. The rate of
capitalization appropriate to the risk class to which the company belongs is 10%.

(i) CALCULATE the market price per share when expected dividends are: (a) declared, and
(b) not declared, based on the Miller – Modigliani approach.

(ii) CALCULATE number of shares to be issued by the company at the end of the
accounting year on the assumption that the net income for the year is ₹ 3 crore,
investment budget is ₹ 6 crores, when (a) Dividends are declared, and (b) Dividends are
not declared.

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(iii) PROOF that the market value of the shares at the end of the accounting year will
remain unchanged irrespective of whether (a) Dividends are declared, or (ii) Dividends are
not declared.

Ans7. (i) Calculation of market price per share

According to Miller – Modigliani (MM) Approach:

Where,

Existing market price ( ) = ₹ 150

Expected dividend per share ( ) =₹8

Capitalization rate ( ) = 0.10

Market price at year end ( ) = to be determined

(a) If expected dividends are declared, then

Rs.150 =

∴ P1 = Rs.157

(b) If expected dividends are not declared, then

Rs.150 =

∴ P1 = Rs.165

(ii) Calculation of number of shares to be issued

(a) (b)
Dividends Dividends
are declared Are not declared
(Rs.lakh) (Rs.lakh)
Net income 300 300
Total dividends (80) -
Retained earnings 220 300
Investment budget 600 600
Amount to be raised by new issues 380 300
Relevant market price (Rs.per share) 157 165
No. of new shares to be issued (in lakh)(Rs.380 2.42 1.82
÷ 157; ₹ 300 ÷ 165)

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(iii) Calculation of market value of the shares

(a) (b)
Dividends are Dividends are
declared Not declared
Existing shares (in lakhs) 10.00 10.00
New shares (in lakhs) 2.42 1.82
Total shares (in lakhs) 12.42 11.82
Market price per share (Rs.) 157 165
Total market value of shares 12.42 × 157 11.82 × 165
at the end of the year (Rs.in = 1,950 (approx.) = 1,950 (approx.)
lakh)
Hence, it is proved that the total market value of shares remains unchanged irrespective of
whether dividends are declared, or not declared.

Q8. Mr H is currently holding 1,00,000 shares of HM ltd, and currently the share of HM ltd
is trading on Bombay Stock Exchange at Rs.50 per share. Mr A have a policy to re-invest
the amount of any dividend received into the shared back again of HM ltd. If HM ltd has
declared a dividend of Rs.10 per share, please determine the no of shares that Mr A would
hold after he re-invests dividend in shares of HM ltd.

Ans8. Ex-dividend price is Rs.40 (50-10).

The total amount of dividend received is Rs.10,00,000 which is re-invested at the rate of
Rs.40 per share.

Hence additional shares purchased would be 25,000. Total holding would be 1,25,000
shares (1,00,000 + 25,000)

Q9. Following information is given pertaining to DG ltd,

No of shares outstanding 1 lakh shares

Earnings Per share 25 per share

P/E Ratio 20

Book Value per share 400 per share

If company decides to repurchase 5,000 shares, at the prevailing market price, what is the
resulting book value per share after repurchasing.

Ans9. Current Market price = 20x25 = 500 per share

Book value of the company before repurchase = Rs.4 cr (400x1 lakh shares)

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Amount paid for repurchase = 1.25 cr (25,000 shares x 500 per share)

Book Value of company after repurchase = Rs.2.75 cr (4cr – 1.25cr)

No of shares after repurchase = 75,000 shares

Book value per share = 367 per share.

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