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Solution of Test of Dividend Policy

[SFM CA Final]

Conducted on 21st August 2010

Q1 For a firm current earnings per share is Rs.2 and last dividend paid is Re.0.4. For the next five years the firm is expected to grow at a high rate of 24% during which its retention ratio shall be 80% and its equity beta shall be 1.5. Thereafter, there shall be an intermediate transition period of five years during which the dividend payout ratio shall increase from 20% at the end of 5th year to 70% at the end of 10th year by way of linear increments each year. There shall be no change in the cost of equity and the growth rate of the firm shall be 20% in year 6, 16% in year 7, 12% in year 8, 8% in year 9 and 6% in year 10. From the end of 10th year till perpetuity the firm shall grow at the rate of 4%, its dividend payout ratio shall be 70% and its equity beta shall settle at 1. The risk free rate of return is 7.5% and the market risk premium is 5.5%. Applying Capital Asset Pricing Model (CAPM), find the price of share as on today as per the Gordons Dividend Model. A client of yours is interested in buying this share which currently trades at Rs.35. What shall be your advice? (10 Marks) Solution: Valuation of Shares as per Gordons Dividend Model: Year EPS 1 2.48 2 3.08 3 3.81 4 4.73 5 5.86 6 7.04 7 8.16 8 9.14 9 9.87 10 10.47 10 D / P Ratio 20 % 20 % 20 % 20 % 20 % 30 % 40 % 50 % 60 % 70 % DPS 0.496 0.616 0.762 0.946 1.172 2.112 3.264 4.570 5.922 7.329 84.609* PVF (15.75%) .864 .746 .645 .557 .481 .416 .359 .310 .268 .232 .232 PV 0.4285 0.4595 0.4915 0.5269 0.5637 0.8786 1.1718 1.4167 1.5871 1.7003 9.2246 19.6482 28.8728

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Cost of equity for high growth and transition period: ke = 7.5 + 1.5 [5.5] = 15.75 % Cost of equity for stable period: ke = 7.5 + 1 [5.5] = 13 % *Continuing Value of Dividend: Continuing value = 7.329 + 4 % / 13 % 4 % = 84.6907 Recommendation: The current MPS (Rs.35) is higher than fundamental value of share (Rs.28.87). Thus, the share is overpriced and hence not worth purchasing.

Solution prepared by Q2

CA. Ashish Lalaji

A Ltd. has surplus cash of Rs.80 lakhs and wants to distribute 30 % of it to the shareholders. The company has decided to buyback shares. The finance manager of the company has estimated that the share price after buyback shall be 10 % higher than the buyback price, if the buyback route is taken. Currently the number of shares is 10 lakhs and the EPS is Rs.3. You are required to determine:

i. The price at which the shares can be repurchas ed if the market capitalisation of the company should be Rs.180 lakhs after buyback ii. The number of shares that can be repurchased iii. The impact of share repurchase on the EPS assuming same level of total earnings (10 Marks) Solution: (i) Let P be the buyback price. Thus, price after buyback shall be 1.1P. Now, market capitalisation after buyback shall be: 1.1P (Original Shares Shares Repurchased), which has to be Rs.180 lakhs. Further, 30 % of Rs.80 lakhs is to be distributed i.e. Rs.24 lakhs. Hence, no. of shares repurchased shall be: 24 / P. Based on above, following equation has been developed and solved: 1.1P (Original Shares Shares Repurchased) = 180 i.e. 1.1P (10 24/P) = 180 i.e. 11P 26.4 = 180 i.e. P = Rs.18.76 (ii) (iii) No. of shares repurchased = 24 / 18.76 = 1.2793 ~ 1.28 lakh shares. New EPS = (3 X 10) / [10 1.28] = Rs.3.44 Solution prepared by

CA. Ashish Lalaji

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Q3 The managing directors of three profitable companies were discussing their companies dividend policies over lunch. Each managing director is certain that his or her companys policy is maximizing shareholder wealth. Company A has deliberately not paid any dividends over the last five years Company B pays dividend of 50% of earnings after taxation Company C maintains a constant dividend rate of 15% coupled with extra dividends in years of high profits Discuss the circumstances in which the dividend policies may be maximizing shareholders wealth. What are the advantages and disadvantages of each dividend policy? (10 Marks) Solution: Circumstances under which different dividend policies shall maximize shareholders wealth: Company A: Company A is deliberately not paying dividend. This may be on account of the fact that it is a newly formed company. Such companies need to conserve cash to finance their expansion activities. Even if the company is a fast growing firm it may not pay dividend mainly to exploit attractive internal investment opportunities. In such a scenario, the share prices shall still rise in expectations of higher profits. Later on such companies may declare bonus shares and capitalize their reserves. Advantage: The major advantage of not paying dividend is that company need not resort to borrowings to arrange for funds to finance its growth. Thus, internal cash generated shall be deployed in the fast growing or the newly formed business of the company itself. Disadvantage: This policy shall fail to attract investors in need of regular income in form of dividend. Company B: Company Bs policy shall work if its earnings are inconsistent. If the business of company B is cyclic in nature or giving rise to sporadic returns linking dividend to earnings makes sense. Advantage: There is no burden to maintain dividend rate. Hence, in years in which profits are on the lower side the company needs to pay only a fixed proportion of income by way of dividend. Disadvantage: This policy shall fail to attract investors in need of regular income in form of dividend. Company C: Shareholders invest in companies in anticipation of handsome returns. If a company pays regular dividend and extra dividends at time of additional profits the policy satisfies each and every type of investor. This helps the firm in improving its reputation amongst the investors thereby increasing its prices.

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Advantage: As stated above, this policy attracts all types of investors. Even senior citizens and pensioners shall not mind investing in shares of such companies, as there is certainty as to dividends. Disadvantage: The firm shall be under immense pressure to maintain dividend rate even in years in which its performance is not satisfactory. If on account of reduced profits or no profits if dividend rate is reduced or dividend is not declared at all, it shall not be well accepted by its investors. It shall bring down investor sentiments and thereby its share prices. Solution prepared by

CA. Ashish Lalaji