The following information is supplied to you: Particulars Amount (₹) Total Earnings 8,00,000 Equity Shares (of ₹ 100 each) 40,00,000 Dividend Paid…

Number of equity shares (₹ 40,00,000 ÷ ₹ 100) 40,000 shares Earnings per share, EPS (₹ 8,00,000 ÷ 40,000) ₹ 20.00 Dividend per share, DPS (₹ 4,80,000 ÷ 40,000) ₹ 12.00 Rate of return, r (₹ 8,00,000 ÷ ₹ 40,00,000) 20% Cost of equity, Ke (inverse of P/E ratio = 1 ÷ 10) 10% (i) Is the Dividend Policy Optimal? Walter's Model values a share as: P = D + r/Ke (E-D) / Ke Substituting the values (D = ₹ 12, E = ₹ 20, r = 20%, Ke = 10%): P = 12 + 0.20/0.10 (20 - 12) / 0.10 = ₹ 280.00 Since the firm's rate of return, r (20%), is greater than its cost of equity, Ke (10%), it is a growth firm. For a growth firm, Walter's Model prescribes a zero payout as the optimal policy. By retaining 100% of earnings, the value of the share would be: P = 0 + 0.20/0.10 (20 - 0) / 0.10 = ₹ 400.00 Conclusion: Since r > Ke, the company is NOT following an optimal dividend policy. Retaining the entire earnings (zero payout) would raise the share value from ₹ 280 to ₹ 400. (ii) P/E Ratio at which Dividend Policy Has No Effect Dividend policy becomes irrelevant to value only when Ke equals r, i.e. Ke = 20%. The corresponding P/E ratio is: P/E = 1/Ke = 1/0.20 = 5 (iii) Effect of a Lower P/E Ratio (P/E = 4) If the P/E ratio is 4, the cost of equity becomes: Ke = 1/4 = 25% Recomputing the share value with r = 20%, Ke = 25%, D = ₹ 12, E = ₹ 20 P = D + r/Ke (E-D) / Ke P = 12 + 0.20/0.25 (20-12) / 0.25 = ₹ 73.60 Here, r (20%) is now less than Ke (25%) the firm has become a declining firm. For a declining firm, Walter's Model prescribes a 100% payout as the optimal policy, the opposite of the conclusion in part (i). Conclusion: YES, the decision changes. With P/E = 4 (r < Ke), the optimal policy reverses to full (100%) payout, instead of zero payout.