Question

Walter and Gordon model analyse the impact of distribution of dividends on the valuation of the firm but the formula used in both the cases are different. Company ABC Ltd wanted to evaluate the price of the share in both cases. The company earns ₹ 50 per share and expects the same for the next year. The cost of capital to the firm is 11%. The company earns return on investment of 15% and the firm is planning dividend payout ratio of 60%. Calculate:
a. Price of the share using Walter Model. Comment on the relationship between return on investment and cost of capital in the case above and decision of the firm whether dividend is to be declared or not.
b.Price of the share using Gordon model. Comment on the relationship between return on investment and cost of capital in the case above and decision of the firm whether dividend is to be declared or not.

Answer 1

EPS = ₹50 per share

Cost of capital (k)= 11%

Return on investment (r)= 15%

Dividend payout ratio (DPR)= 60%

Dividend per share $=60 \%{ }^{\star} 50= 30$

Explanation:

(a) As per Walter Model price of share is-

$\begin{aligned}&=\frac{D+\frac{r}{k}(E-D)}{k} \\&=\frac{30+\frac{0.15}{0.11}(50-30)}{0.11} \\&=\frac{57.2727}{0.11} \\&=\mathbf{5 2 0 . 6 6}\end{aligned}$

Market value of share is $Rs. 520.66$

According to Walter's model, a company's dividend policy has an impact on shareholders' wealth, and a company's dividend policy is based on IRR and cost of capital.

(b) Gordon Model price

Because the growth rate isn't specified, we'll assume that the dividend remains constant and that the growth rate is 0.

As per Gordon Model price of share is-

= Dividend per share/ Required rate of return

= ₹30/0.15

= ₹200

According to the Gordon Model, a company's dividend decisions affect its value, and a share's market value is equal to the present value of its predicted future dividends.

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