Test 1: Dividend Decisions: answer key

Question 1 · 2 marks · Dividend Decisions · medium

Scenario. Bharat Renewables Ltd. (BRL) is a mid-cap manufacturer of solar inverters and grid-interface equipment. Its long-term funds are made up of equity share capital of ₹2,00,00,000 (20,00,000 fully paid equity shares of ₹10 each) and 12% non-convertible debentures of ₹2,00,00,000. There is no preference capital. The company has completed its capacity-expansion cycle and expects a stable EBIT of ₹1,20,00,000 per annum for the foreseeable future. The applicable corporate tax rate is 25%. Based on its beta and market conditions, the cost of equity (Ke) of BRL has been estimated at 12%. The company's past investments in distribution and after-sales service have consistently generated an internal rate of return (r) of 15% on retained funds, and the CFO believes this rate is sustainable for all incremental retained earnings. Historical dividend record of BRL: Particulars | Amount Equity share capital | ₹2,00,00,000 12% Debentures | ₹2,00,00,000 Expected EBIT (stable) | ₹1,20,00,000 p.a. Corporate tax rate | 25% Cost of equity (Ke) | 12% Internal rate of return (r) | 15% Current dividend payout ratio | 50% of earnings The Board is reviewing its dividend policy using Walter's model and is also examining how a possible fall in the internal rate of return to 9% (if the new inverter technology fails to earn the projected margins) would alter the appropriate payout decision. The company has no fresh equity issue plans and finances all investments out of internal accruals.

For Bharat Renewables Ltd., what is the Earnings Per Share (EPS) available to equity shareholders?

1. ₹4.80
2. ₹4.50
3. ₹3.60 (correct answer)
4. ₹4.00

Answer: C — ₹3.60

Explanation. Step 1: Interest = 12% × ₹2,00,00,000 = ₹24,00,000. Step 2: PBT = ₹1,20,00,000 − ₹24,00,000 = ₹96,00,000. Step 3: Tax @25% = ₹24,00,000; PAT = ₹72,00,000. Step 4: There is no preference capital, so earnings for equity = ₹72,00,000. Step 5: EPS = ₹72,00,000 ÷ 20,00,000 shares = ₹3.60. Option (a) ₹4.80 is PBT per share (tax ignored); option (b) ₹4.50 is EBIT(1−t) ÷ shares, which wrongly ignores the interest charge on debentures.

Where it goes wrong. Ignoring either the debenture interest or the tax charge while deriving EPS; Walter's model must be fed with post-tax equity EPS.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 2 · 2 marks · Dividend Decisions · medium

Using Walter's model, what will be the market price per share of Bharat Renewables Ltd. if it continues with the existing 50% dividend payout ratio?

1. ₹37.50
2. ₹33.75 (correct answer)
3. ₹34.50
4. ₹30.00

Answer: B — ₹33.75

Explanation. DPS = 50% of ₹3.60 = ₹1.80. r/Ke = 15/12 = 1.25. Walter's price = [D + (r/Ke)(E − D)] ÷ Ke = [1.80 + 1.25 × (3.60 − 1.80)] ÷ 0.12 = [1.80 + 2.25] ÷ 0.12 = 4.05 ÷ 0.12 = ₹33.75. Option (a) ₹37.50 is the price at zero payout (the optimum), not at 50%; option (d) ₹30.00 is the price at 100 percent payout.

Where it goes wrong. Dividing only the DPS-plus-retained-earnings term by Ke without applying the r/Ke multiplier to retained earnings.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 3 · 2 marks · Dividend Decisions · medium

Given r = 15% and Ke = 12%, which payout ratio maximises the market price of Bharat Renewables Ltd. under Walter's model, and what is that maximum price?

1. 100 percent payout; ₹30.00
2. 40% payout; ₹34.50
3. 50% payout; ₹33.75
4. 0% payout; ₹37.50 (correct answer)

Answer: D — 0% payout; ₹37.50

Explanation. Since r (15%) > Ke (12%), BRL is a growth firm; every rupee retained earns more than shareholders' required return, so the optimum payout is zero. Price = [(r/Ke) × E] ÷ Ke = [1.25 × 3.60] ÷ 0.12 = 4.50 ÷ 0.12 = ₹37.50. For verification, a 40% payout gives [1.44 + 1.25 × 2.16] ÷ 0.12 = ₹34.50, and a 100 percent payout gives 3.60 ÷ 0.12 = ₹30.00 — both lower than ₹37.50.

Where it goes wrong. Assuming a high payout always supports the price; under Walter's model the direction depends entirely on whether r exceeds Ke.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 4 · 2 marks · Dividend Decisions · medium

If BRL's internal rate of return falls to 9% (with Ke unchanged at 12% and EPS at ₹3.60), what is the optimal payout ratio and the resulting market price per share under Walter's model?

1. 0% payout; ₹22.50
2. 0% payout; ₹37.50
3. 100 percent payout; ₹30.00 (correct answer)
4. 50% payout; ₹26.25

Answer: C — 100 percent payout; ₹30.00

Explanation. Now r (9%) < Ke (12%), so BRL becomes a declining firm and the optimum payout is 100 percent. Price = [3.60 + (9/12)(0)] ÷ 0.12 = 3.60 ÷ 0.12 = ₹30.00. At 0% payout the price falls to [0.75 × 3.60] ÷ 0.12 = ₹22.50, and at 50% payout it is [1.80 + 0.75 × 1.80] ÷ 0.12 = ₹26.25. Option (b) wrongly reuses the earlier 15% growth-firm valuation.

Where it goes wrong. Retaining the original 0% optimal payout after the r-vs-Ke relationship reverses, or reusing ₹37.50 from the growth-firm case.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 5 · 2 marks · Dividend Decisions · medium

Scenario. Aditya Automotive Ltd. (AAL) manufactures precision transmission components for passenger vehicles. The company is financed by equity shares, preference shares and debentures as follows: Particulars | Amount Equity share capital (10,00,000 shares of ₹10 each) | ₹1,00,00,000 12% Preference share capital | ₹50,00,000 10% Debentures | ₹1,50,00,000 Expected EBIT (stable) | ₹1,05,00,000 p.a. Corporate tax rate | 30% Cost of equity (Ke) | 15% Internal rate of return (r) | 18% Current dividend payout ratio | 50% of equity earnings AAL has consistently ploughed back a part of its equity earnings into tooling and CNC upgrades which earn an internal return of 18%, comfortably above the 15% return its shareholders expect. The company has never issued fresh equity after its IPO and meets all investment needs from retained earnings. The Board, however, is under pressure from a section of institutional investors to raise the dividend payout. The finance team has been asked to evaluate the impact of alternative payout ratios on the market price using Walter's model, and separately to examine the position if the internal rate of return were to decline to 12% because of aggressive price competition from imported components.

For Aditya Automotive Ltd., what is the Earnings Per Share attributable to equity shareholders?

1. ₹5.70 (correct answer)
2. ₹6.30
3. ₹9.00
4. ₹4.56

Answer: A — ₹5.70

Explanation. Interest = 10% × ₹1,50,00,000 = ₹15,00,000; PBT = ₹1,05,00,000 − ₹15,00,000 = ₹90,00,000; Tax @30% = ₹27,00,000; PAT = ₹63,00,000. Preference dividend = 12% × ₹50,00,000 = ₹6,00,000. Earnings for equity = ₹57,00,000; EPS = ₹57,00,000 ÷ 10,00,000 = ₹5.70. Option (b) ₹6.30 is PAT per share before the preference dividend, a classic error when the capital structure includes preference shares.

Where it goes wrong. Forgetting to deduct the preference dividend before computing the EPS that feeds into Walter's model.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 6 · 2 marks · Dividend Decisions · medium

Applying Walter's model, what is the market price per share of Aditya Automotive Ltd. at its current 50% payout ratio?

1. ₹41.80 (correct answer)
2. ₹45.60
3. ₹38.00
4. ₹41.04

Answer: A — ₹41.80

Explanation. DPS = 50% × ₹5.70 = ₹2.85; r/Ke = 18/15 = 1.20. Price = [2.85 + 1.20 × (5.70 − 2.85)] ÷ 0.15 = [2.85 + 3.42] ÷ 0.15 = 6.27 ÷ 0.15 = ₹41.80. Option (b) ₹45.60 is the zero-payout valuation, and option (c) ₹38.00 is the full-payout valuation — both are endpoints, not the current policy value.

Where it goes wrong. Substituting the full EPS into the numerator (which gives the 100 percent payout price) instead of the actual DPS.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 7 · 2 marks · Dividend Decisions · medium

If the Board of Aditya Automotive Ltd. wishes to maximise the share price under Walter's model, which payout ratio should it adopt and what price will result?

1. 50% payout; ₹41.80
2. 100 percent payout; ₹38.00
3. 0% payout; ₹47.50
4. 0% payout; ₹45.60 (correct answer)

Answer: D — 0% payout; ₹45.60

Explanation. r = 18% > Ke = 15%, hence AAL is a growth firm and the optimum payout is nil. Price = [(18/15) × 5.70] ÷ 0.15 = 6.84 ÷ 0.15 = ₹45.60. Option (c) ₹47.50 arises from dividing by 0.15 after multiplying 5.70 by 1.25 but using an inflated numerator; option (b) ₹38.00 is the full-payout price, the worst case for a growth firm.

Where it goes wrong. Choosing the highest-numbered option or computing 5.70 × 1.25 ÷ 0.15 incorrectly, and ignoring that zero payout is optimal only when r > Ke.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 8 · 2 marks · Dividend Decisions · medium

If AAL's internal rate of return declines to 12% (Ke remaining 15%, EPS ₹5.70), what is the optimal payout ratio and the corresponding market price per share under Walter's model?

1. 0% payout; ₹45.60
2. 100 percent payout; ₹38.00 (correct answer)
3. 50% payout; ₹34.20
4. 0% payout; ₹30.40

Answer: B — 100 percent payout; ₹38.00

Explanation. With r (12%) < Ke (15%), AAL becomes a declining firm; retention destroys value, so a 100 percent payout is optimal. Price = 5.70 ÷ 0.15 = ₹38.00, independent of r once the whole earnings are distributed. At 50% payout the price would be [2.85 + 0.80 × 2.85] ÷ 0.15 = 5.13 ÷ 0.15 = ₹34.20, and at zero payout [0.80 × 5.70] ÷ 0.15 = ₹30.40.

Where it goes wrong. Continuing with the 0% payout optimum from the growth-firm case, or failing to notice that at 100 percent payout the price depends only on E and Ke.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 9 · 2 marks · Dividend Decisions · medium

Scenario. Sunrise Ceramics Ltd. has an EPS of ₹10, an internal rate of return of 10% and a cost of equity of 12%. Its shares currently trade at ₹75 per share. Under Walter's model, what Dividend Per Share is implied by this market price?

Sunrise Ceramics Ltd. has an EPS of ₹10, an internal rate of return of 10% and a cost of equity of 12%. Its shares currently trade at ₹75 per share. Under Walter's model, what Dividend Per Share is implied by this market price?

1. ₹3.00
2. ₹5.00
3. ₹6.00
4. ₹4.00 (correct answer)

Answer: D — ₹4.00

Explanation. Walter's formula: 75 = [D + (10/12)(10 − D)] ÷ 0.12. Multiplying through: 9.00 = D + 8.3333 − 0.8333D, so 0.1667D = 0.6667, giving D = ₹4.00. Verification: [4 + 0.8333 × 6] ÷ 0.12 = [4 + 5.00] ÷ 0.12 = 9 ÷ 0.12 = ₹75. Option (c) ₹6.00 would give [6 + 3.3333] ÷ 0.12 = ₹77.78, not ₹75.

Where it goes wrong. Substituting the market price into the numerator instead of solving for D, or ignoring the (r/Ke) multiplier on retained earnings.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 10 · 2 marks · Dividend Decisions · medium

Scenario. Kaveri Textiles Ltd. has an EPS of ₹8 and pays a DPS of ₹4. Its cost of equity is 10% and its shares are quoted at ₹100 — a price that is fully explained by Walter's model. What internal rate of return (r) is implied?

Kaveri Textiles Ltd. has an EPS of ₹8 and pays a DPS of ₹4. Its cost of equity is 10% and its shares are quoted at ₹100 — a price that is fully explained by Walter's model. What internal rate of return (r) is implied?

1. 10%
2. 15% (correct answer)
3. 12%
4. 18%

Answer: B — 15%

Explanation. Walter's model: 100 = [4 + (r/0.10)(8 − 4)] ÷ 0.10 → 10 = 4 + 40r → 40r = 6 → r = 15%. Verification: [4 + (0.15/0.10) × 4] ÷ 0.10 = [4 + 6] ÷ 0.10 = 10 ÷ 0.10 = ₹100. Option (a) 10% would give [4 + 1 × 4] ÷ 0.10 = ₹80, and option (c) 12% would give [4 + 4.80] ÷ 0.10 = ₹88, both below the observed price.

Where it goes wrong. Setting r equal to Ke because EPS is exactly twice DPS, instead of solving the Walter equation for the implied r.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 11 · 2 marks · Dividend Decisions · medium

Scenario. Which of the following is NOT an assumption underlying Walter's dividend model?

Which of the following is NOT an assumption underlying Walter's dividend model?

1. All investment proposals of the firm are financed only through retained earnings
2. The internal rate of return (r) and the cost of capital (Ke) remain constant
3. The growth rate of the firm's earnings is constant and equal to br (correct answer)
4. The firm is assumed to have a perpetual life with constant EPS and DPS

Answer: C — The growth rate of the firm's earnings is constant and equal to br

Explanation. Walter's model rests on: financing of all investment out of retained earnings only, constant r and constant Ke, perfect capital markets, no taxes and no flotation costs, perpetual life with constant EPS and DPS. The constant growth formulation g = b × r is the defining assumption of Gordon's growth model, not of Walter's price equation, which is a single-period valuation relating D, E, r and Ke.

Where it goes wrong. Confusing the growth-rate assumption (g = br) of Gordon's model with the assumptions of Walter's model, since both are 'relevance' theories.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 12 · 2 marks · Dividend Decisions · medium

Scenario. Nalanda Cements Ltd. has an EPS of ₹12, an internal rate of return of 14% and a cost of equity of 14%. What market price per share will Walter's model give, and what does it imply about the dividend policy?

Nalanda Cements Ltd. has an EPS of ₹12, an internal rate of return of 14% and a cost of equity of 14%. What market price per share will Walter's model give, and what does it imply about the dividend policy?

1. ₹85.71 at every payout ratio; the firm is indifferent to its dividend policy (correct answer)
2. ₹120.00 at zero payout and ₹85.71 at 100 percent payout; retention is preferable
3. ₹75.00 at 100 percent payout; a 100 percent payout is optimal
4. ₹100.00 at zero payout; the policy is irrelevant only at 50% payout

Answer: A — ₹85.71 at every payout ratio; the firm is indifferent to its dividend policy

Explanation. When r = Ke, the term (r/Ke)(E − D) equals (E − D), so the numerator collapses to D + E − D = E and price becomes E/Ke = 12 ÷ 0.14 = ₹85.71 at any payout. At 0% payout: [1 × 12] ÷ 0.14 = ₹85.71; at 100 percent payout: 12 ÷ 0.14 = ₹85.71. Option (b) wrongly assumes that r = Ke still favours retention.

Where it goes wrong. Assuming r = Ke makes retention preferable, or mechanically applying the growth-firm rule r > Ke.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 13 · 2 marks · Dividend Decisions · medium

Scenario. Vindhya Power Ltd. earns ₹10 per share, has an internal rate of return of 20% and a cost of equity of 10%. If the company follows a 40% dividend payout ratio, what is its market price per share under Walter's model?

Vindhya Power Ltd. earns ₹10 per share, has an internal rate of return of 20% and a cost of equity of 10%. If the company follows a 40% dividend payout ratio, what is its market price per share under Walter's model?

1. ₹140.00
2. ₹200.00
3. ₹160.00 (correct answer)
4. ₹120.00

Answer: C — ₹160.00

Explanation. DPS = 40% × ₹10 = ₹4; r/Ke = 20/10 = 2. Price = [4 + 2 × (10 − 4)] ÷ 0.10 = [4 + 12] ÷ 0.10 = 16 ÷ 0.10 = ₹160.00. Option (b) ₹200.00 is the price at 0% payout (the optimum for a growth firm), and option (d) ₹120.00 would arise from applying a multiplier of only 1.8 to retained earnings.

Where it goes wrong. Treating the retained earnings (₹6) as the numerator and forgetting to add back the DPS of ₹4 before dividing by Ke.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 14 · 2 marks · Dividend Decisions · medium

Scenario. Sahyadri Papers Ltd. has an EPS of ₹6, an internal rate of return of 12% and a cost of equity of 15%. It currently pays a DPS of ₹3. Under Walter's model, what is the optimal payout ratio and the resulting price per share?

Sahyadri Papers Ltd. has an EPS of ₹6, an internal rate of return of 12% and a cost of equity of 15%. It currently pays a DPS of ₹3. Under Walter's model, what is the optimal payout ratio and the resulting price per share?

1. 0% payout; ₹32.00
2. 100 percent payout; ₹40.00 (correct answer)
3. 50% payout; ₹36.00
4. 75% payout; ₹38.00

Answer: B — 100 percent payout; ₹40.00

Explanation. r (12%) < Ke (15%), so the firm is a declining firm and 100 percent payout is optimal. Price = 6 ÷ 0.15 = ₹40.00. At the current 50% payout the price is [3 + 0.8 × 3] ÷ 0.15 = 5.40 ÷ 0.15 = ₹36.00, and at 0% payout it is [0.8 × 6] ÷ 0.15 = ₹32.00 — both below ₹40.00, confirming that distribution adds value here.

Where it goes wrong. Applying the growth-firm logic (0% payout) despite r being below Ke, which reverses the optimal policy.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 15 · 2 marks · Dividend Decisions · medium

Scenario. Meghdoot Ltd. has an EPS of ₹6, an internal rate of return of 18% and a cost of equity of 12%. By how much will the market price per share rise if the company moves from a 25% payout ratio to the optimal payout ratio under Walter's model?

Meghdoot Ltd. has an EPS of ₹6, an internal rate of return of 18% and a cost of equity of 12%. By how much will the market price per share rise if the company moves from a 25% payout ratio to the optimal payout ratio under Walter's model?

1. ₹6.25 (correct answer)
2. ₹4.50
3. ₹7.50
4. ₹5.00

Answer: A — ₹6.25

Explanation. r/Ke = 18/12 = 1.5 and r > Ke, so the optimum payout is 0%. At 25% payout, D = ₹1.50: [1.50 + 1.5 × 4.50] ÷ 0.12 = [1.50 + 6.75] ÷ 0.12 = 8.25 ÷ 0.12 = ₹68.75. At 0% payout: [1.5 × 6] ÷ 0.12 = 9 ÷ 0.12 = ₹75.00. Increase = ₹75.00 − ₹68.75 = ₹6.25. Option (c) ₹7.50 mistakenly multiplies the DPS by r/Ke.

Where it goes wrong. Computing the price change as a percentage of EPS or applying the multiplier to the dividend instead of to retained earnings.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 16 · 2 marks · Dividend Decisions · medium

Scenario. Trinetra Ltd. has an EPS of ₹10, an internal rate of return of 18% and a cost of equity of 12%. Its Board wants the share to be quoted at exactly ₹100 on the strength of Walter's model. What payout ratio should the company adopt?

Trinetra Ltd. has an EPS of ₹10, an internal rate of return of 18% and a cost of equity of 12%. Its Board wants the share to be quoted at exactly ₹100 on the strength of Walter's model. What payout ratio should the company adopt?

1. 40%
2. 50%
3. 75%
4. 60% (correct answer)

Answer: D — 60%

Explanation. Set 100 = [D + 1.5(10 − D)] ÷ 0.12 → 12 = D + 15 − 1.5D → 0.5D = 3 → D = ₹6, i.e. a payout of 6/10 = 60%. Verification: [6 + 1.5 × 4] ÷ 0.12 = 12 ÷ 0.12 = ₹100. A 50% payout gives [5 + 7.50] ÷ 0.12 = ₹104.17 and a 40% payout gives [4 + 9] ÷ 0.12 = ₹108.33, both above the target.

Where it goes wrong. Dividing the target price by EPS or by Ke instead of solving the Walter equation for D.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 17 · 2 marks · Dividend Decisions · medium

Scenario. Himalaya Engineering Ltd. earns ₹15 per share, has an internal rate of return of 8% and a cost of equity of 10%. It currently retains 50% of earnings. What is the loss of value per share caused by this retention, compared with the optimal policy under Walter's model?

Himalaya Engineering Ltd. earns ₹15 per share, has an internal rate of return of 8% and a cost of equity of 10%. It currently retains 50% of earnings. What is the loss of value per share caused by this retention, compared with the optimal policy under Walter's model?

1. ₹15.00 (correct answer)
2. ₹10.00
3. ₹22.50
4. ₹7.50

Answer: A — ₹15.00

Explanation. Since r (8%) < Ke (10%), a 100 percent payout is optimal: price = 15 ÷ 0.10 = ₹150.00. At the current 50% payout, D = ₹7.50 and r/Ke = 0.8: [7.50 + 0.8 × 7.50] ÷ 0.10 = [7.50 + 6.00] ÷ 0.10 = 13.50 ÷ 0.10 = ₹135.00. Value destroyed = ₹150.00 − ₹135.00 = ₹15.00, equal to the retained amount of ₹7.50 that earns only 8% against a 10% requirement, capitalised at Ke.

Where it goes wrong. Comparing prices at the wrong payout ratios, or measuring the loss as the retained amount (₹7.50) rather than its capitalised value.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 18 · 2 marks · Dividend Decisions · medium

Scenario. Deccan Alloys Ltd. has an EBIT of ₹1,00,00,000, 10% debentures of ₹2,00,00,000 outstanding, 7,00,000 equity shares and a tax rate of 30%. Its internal rate of return is 15% and cost of equity is 12.5%. If the company follows a full retention policy, what is the market price per share under Walter's model?

Deccan Alloys Ltd. has an EBIT of ₹1,00,00,000, 10% debentures of ₹2,00,00,000 outstanding, 7,00,000 equity shares and a tax rate of 30%. Its internal rate of return is 15% and cost of equity is 12.5%. If the company follows a full retention policy, what is the market price per share under Walter's model?

1. ₹64.00
2. ₹109.71
3. ₹76.80 (correct answer)
4. ₹96.00

Answer: C — ₹76.80

Explanation. Interest = ₹20,00,000; PBT = ₹80,00,000; PAT = ₹56,00,000; EPS = ₹56,00,000 ÷ 7,00,000 = ₹8.00. With zero payout, price = [(r/Ke) × E] ÷ Ke = [1.2 × 8] ÷ 0.125 = 9.60 ÷ 0.125 = ₹76.80. Option (a) ₹64.00 is the 100 percent payout price (8 ÷ 0.125), and option (b) ₹109.71 comes from using pre-tax earnings of ₹11.43 per share.

Where it goes wrong. Using pre-tax earnings per share in Walter's model, or mixing up the zero-payout and full-payout valuations.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 19 · 2 marks · Dividend Decisions · medium

Scenario. Which of the following statements about Walter's dividend model is correct?

Which of the following statements about Walter's dividend model is correct?

1. Walter's model assumes Ke falls as the retention ratio rises, which explains why growth firms command higher prices
2. Walter's model presumes that all investment is financed by retained earnings; hence a firm that pays dividends while simultaneously issuing fresh equity falls outside the model's framework (correct answer)
3. Walter's model requires the firm to maintain a constant debt-equity ratio while declaring dividends
4. Walter's model assumes that EPS falls as the retention ratio increases

Answer: B — Walter's model presumes that all investment is financed by retained earnings; hence a firm that pays dividends while simultaneously issuing fresh equity falls outside the model's framework

Explanation. The core assumption of Walter's model is that investment proposals are financed solely out of retained earnings, with r, Ke, EPS and DPS held constant and no taxes or flotation costs. Therefore a firm that pays a dividend and simultaneously raises fresh equity (as in the MM framework) cannot be valued strictly by Walter's formula. Option (a) confuses Walter's model with the 'bird-in-hand' argument of Gordon's revised model, while (c) describes a capital-structure assumption the model does not make.

Where it goes wrong. Attributing Gordon's bird-in-hand reasoning or a constant debt-equity assumption to Walter's model.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions

Question 20 · 2 marks · Dividend Decisions · medium

Scenario. For Vaigai Ltd., Walter's model gives a price of ₹120 at zero payout and ₹80 at 100 percent payout. The EPS is ₹12 and the cost of equity is 15%. What is the company's internal rate of return (r)?

For Vaigai Ltd., Walter's model gives a price of ₹120 at zero payout and ₹80 at 100 percent payout. The EPS is ₹12 and the cost of equity is 15%. What is the company's internal rate of return (r)?

1. 18.0%
2. 20.0%
3. 25.0%
4. 22.5% (correct answer)

Answer: D — 22.5%

Explanation. At 100 percent payout, price = E/Ke = 12 ÷ 0.15 = ₹80, which matches the data and confirms E and Ke. At zero payout, price = (r/Ke) × E ÷ Ke → 120 = (r/0.15) × 12 ÷ 0.15 → 120 × 0.15 = (r/0.15) × 12 → 18 = 12r/0.15 → r = 18 × 0.15 ÷ 12 = 0.225, i.e. 22.5%. Verification: [1.5 × 12] ÷ 0.15 = ₹120.

Where it goes wrong. Solving r from the absolute price difference (₹40) or treating the zero-payout price as E ÷ (Ke − r), which is Gordon's formulation.

Authority. ICAI SM: Financial Management and Strategic Management, Dividend Decisions