The following information is supplied to you: (₹) Total Earnings 2,00,000 No. of equity shares (of 100 each) 20,000 Dividend paid 1,50,000 Price/…

(i) The EPS of the firm is 10 (i.e.,2,00,000/ 20,000) and r = 2,00,000/ (20,000 shares × ₹ 100) = 10%. The P/E Ratio is given at 12.5 and the cost of capital, Ke, may be taken at the inverse of P/E ratio. Therefore, Ke is 8 (i.e., 1/12.5). The firm is distributing total dividends of 1,50,000 among 20,000 shares, giving a dividend per share of7.50. the value of the share as per Walter's model may be found as follows: P = D+ r K e (E-D) K e = 7.5 + 0.1 0.08 (10-7.5) 0.08 = 132.81 The firm has a dividend payout of 75% (i.e.,1,50,000) out of total earnings of 2,00,000. Since, the rate of return of the firm, r, is 10% and it is more than the K e of 8%, therefore, by distributing 75% of earnings, the firm is not following an optimal dividend policy. The optimal dividend policy for the firm would be to pay zero dividend and in such a situation, the market price would be- P = 0+ 0.1 0.08 (10-0) 0.08 = 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 K e would be equal to the rate of return, r, of the firm. The K e 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 K e which is the inverse of P/E ratio, would be 12.5 and in such a situation k e > r and the market price, as per Walter's model would be: P = D+ r K e (E-D) K e = 7.5 + 0.1 0.125 (10-7.5) 0.125 = 76 So, the market price will come down to 76.