ABC Ltd. is a listed company operating in the FMCG sector. The company is currently facing a dilemma regarding its dividend policy. The financial…

CA Intermediate · Financial Management and Strategic Management · MTP · September 2025
ABC Ltd. is a listed company operating in the FMCG sector. The company is currently facing a dilemma regarding its dividend policy. The financial controller has been asked to prepare a report for the Board of Directors evaluating whether the company should retain more profits or distribute higher dividends. The following financial data is available for the year ended 31st March 2025: Earnings per share (EPS):10 Dividend per share (proposed):6 Number of equity shares: 10,00,000 Return on investment (r): 15% Cost of equity capital (Ke): 12% Current market price per share:100 Retention ratio: 40% Tax rate: 30% Corporate bond yield: 8% (for comparison with cost of equity) Further, the company has an investment proposal requiring - 30,00,000 with an expected return of 14%. If the dividend is increased to 7/share, the share price is expected to rise to 104 and if the dividend is reduced to 4/share, the share price may fall to 95. The CFO believes that MM hypothesis should be followed, but the Board is inclined towards Walter's model of valuation. You are required to: (i) CALCULATE the value of the share using Walter's Model, and comment whether the current dividend policy is optimal. (ii) Apply Gordon's Model to ESTIMATE the market value of the share. (iii) HOW by way of MM's Dividend Irrelevance Theory, whether a change in dividend payout (from 6 to 7 or - 4) has any impact on the firm's valuation, assuming no taxes and perfect capital markets.

Suggested Answer and Working Notes:

Division B: Descriptive Question 1. (a) (i) Calculation of value of the share using Walter's Model P = D + [ (E - D) / Ke ] / Ke P = 6 + [ 0.15 (10 - 6) / 0.12 ] / 0.12 P = [ 6 + 1.25 × 4 ] / 0.12 = [ 6 + 5 ] / 0.12 = 91.67 Since the market price is 100, and Walter's model gives - 91.67, the current dividend policy is not optimal. (ii) Calculation of value of the share using Gordon's Model P = [ E (1 - b) ] / (Ke - br) g = br = 0.4 × 0.15 = 0.06 So, P = [ 10 × 0.6 ] / (0.12 - 0.06) = 100 This supports the current market price. Since the model gives the same value as the market, the current retention and dividend policy appears acceptable. (iii) MM's Dividend Irrelevance Theory P0 = [ D1 + P1 ] / (1 + Ke) Situation 1: D = 6, P1 = 100, Ke = 12% So, P0 = [ 6 + 100 ] / (1.12) = 94.64 Situation 2: D = 7, P1 = 104, Ke = 12% P0 = [ 7 + 104 ] / (1.12) = 99.11 Situation 3: D = 4, P1 = 95, Ke = 12% P0 = [ 4 + 95 ] / (1.12) = 88.39 So, a change in dividend payout has indeed impacted the firm's valuation.

Topics: Part-A: Financial Management

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