Test 2: Dividend Decisions: answer key

Question 1 · 2 marks · Dividend Decisions · medium

Scenario. Zenith Power Systems Ltd. (ZPSL) is an all-equity company engaged in manufacturing smart metering and grid-automation equipment. The company has 10,00,000 fully paid equity shares of ₹10 each and no debt or preference capital. Its expected EBIT is ₹1,60,00,000 per annum, and the applicable corporate tax rate is 25%. The finance team has estimated the company's cost of equity (Ke) at 12% and the internal rate of return (r) on retained earnings at 15%. ZPSL has consistently retained 40% of its earnings and distributed the balance as dividends. The company does not plan to issue fresh equity and finances all growth investments out of internal accruals. Key financial data: Particulars | Amount Equity share capital (10,00,000 shares of ₹10) | ₹1,00,00,000 Expected EBIT | ₹1,60,00,000 p.a. Corporate tax rate | 25% Expected EPS (E1) | ₹12.00 Cost of equity (Ke) | 12% Internal rate of return (r) | 15% Retention ratio (b) | 40% The Board is evaluating the company's dividend policy using Gordon's dividend growth model. It also wants to test the sensitivity of the share price to a higher retention ratio and to a possible fall in the internal rate of return if competition in the smart-metering business intensifies. The company's shares are currently quoted close to the theoretical price generated by Gordon's model.

Using Gordon's dividend growth model, what is the theoretical market price per share of Zenith Power Systems Ltd. at its current 40% retention ratio?

1. ₹120.00 (correct answer)
2. ₹100.00
3. ₹90.00
4. ₹150.00

Answer: A — ₹120.00

Explanation. Step 1: Growth rate g = b × r = 0.40 × 15% = 6%. Step 2: Dividend per share D1 = E1 × (1 − b) = ₹12 × 0.60 = ₹7.20. Step 3: Gordon's price P0 = D1 ÷ (Ke − g) = 7.20 ÷ (0.12 − 0.06) = 7.20 ÷ 0.06 = ₹120.00. Option (b) ₹100.00 results from using D1 ₹6.00, which wrongly applies a 50% payout; option (c) ₹90.00 arises if the growth rate is taken as 4%.

Where it goes wrong. Using the current dividend instead of D1, or mixing up the retention ratio with the payout ratio while computing g.

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

Question 2 · 2 marks · Dividend Decisions · medium

Under Gordon's model, what is the optimal dividend payout ratio for Zenith Power Systems Ltd. given that r = 15% and Ke = 12%?

1. 100 percent payout
2. 50% payout
3. 0% payout (full retention) (correct answer)
4. Any payout ratio gives the same price

Answer: C — 0% payout (full retention)

Explanation. Under Gordon's model, when the internal rate of return (r) exceeds the cost of equity (Ke), the firm is a growth firm. Retaining earnings creates more value than distributing them because retained funds earn 15% against shareholders' required return of 12%. Therefore, the optimal dividend payout ratio is zero, i.e. full retention. A 100 percent payout is optimal only for a declining firm where r < Ke, and indifference applies only when r = Ke.

Where it goes wrong. Confusing the optimal payout rule for a growth firm (r > Ke → 0%) with that for a declining firm (r < Ke → full).

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

Question 3 · 2 marks · Dividend Decisions · medium

If Zenith Power Systems Ltd. raises its retention ratio to 60%, what will be the market price per share under Gordon's model?

1. ₹120.00
2. ₹160.00 (correct answer)
3. ₹100.00
4. ₹133.33

Answer: B — ₹160.00

Explanation. Step 1: New growth rate g = 0.60 × 15% = 9%. Step 2: D1 = ₹12 × (1 − 0.60) = ₹4.80. Step 3: P0 = 4.80 ÷ (0.12 − 0.09) = 4.80 ÷ 0.03 = ₹160.00. Option (a) ₹120.00 is the price at the existing 40% retention; option (d) ₹133.33 arises from using a growth rate of 8.4% instead of 9%.

Where it goes wrong. Forgetting to update D1 when the retention ratio changes, or applying the old growth rate of 6%.

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

Question 4 · 2 marks · Dividend Decisions · medium

If ZPSL's internal rate of return falls to 10% while the retention ratio remains 40%, what is the market price per share under Gordon's model, and what payout policy becomes optimal?

1. ₹90.00; optimal payout is 100 percent (correct answer)
2. ₹100.00; optimal payout is 0%
3. ₹90.00; optimal payout is 0%
4. ₹120.00; optimal payout is 50%

Answer: A — ₹90.00; optimal payout is 100 percent

Explanation. With r = 10%, g = 0.40 × 10% = 4%. D1 remains ₹7.20. P0 = 7.20 ÷ (0.12 − 0.04) = 7.20 ÷ 0.08 = ₹90.00. Since r (10%) is now below Ke (12%), the firm is a declining firm and the optimal payout is 100 percent, not zero. Option (c) keeps the growth-firm payout rule despite r < Ke, which is the key trap.

Where it goes wrong. Retaining the 0% payout rule after r falls below Ke, or using the old growth rate of 6%.

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

Question 5 · 2 marks · Dividend Decisions · medium

Scenario. Sahyadri Consumer Care Ltd. (SCCL) is a mid-sized manufacturer of personal-care products with a stable dividend record. The company follows Lintner's model of dividend smoothing, under which the current year's dividend is adjusted only partially towards the target dividend based on current earnings. SCCL paid a dividend of ₹5.00 per share last year. For the current year, the company expects earnings per share (EPS) of ₹20.00. The management has set a target dividend payout ratio of 50% and uses an adjustment factor (speed of adjustment) of 0.30. Key dividend data: Particulars | Amount Last year's dividend (D0) | ₹5.00 per share Current year's expected EPS (EPS1) | ₹20.00 Target dividend payout ratio | 50% Adjustment factor (c) | 0.30 SCCL's Board is considering whether the current dividend should be raised gradually in line with Lintner's model or whether a higher adjustment factor should be used to move faster towards the target payout. The company also wants to examine the effect of raising the target payout ratio to 60% on the current year's dividend, keeping the adjustment factor unchanged at 0.30. The finance team has been asked to compute the current dividend, the likely dividend for next year if EPS rises to ₹24.00, and the adjustment factor required to pay ₹8.00 per share this year.

Using Lintner's model, what dividend per share should Sahyadri Consumer Care Ltd. pay in the current year?

1. ₹5.00
2. ₹6.50 (correct answer)
3. ₹7.50
4. ₹10.00

Answer: B — ₹6.50

Explanation. Step 1: Target dividend = EPS1 × target payout = ₹20.00 × 50% = ₹10.00. Step 2: Lintner's model: D1 = D0 + c × (Target DPS − D0) = 5.00 + 0.30 × (10.00 − 5.00) = 5.00 + 1.50 = ₹6.50. Option (c) ₹7.50 uses an adjustment factor of 0.50; option (d) ₹10.00 ignores smoothing and pays the full target immediately.

Where it goes wrong. Paying the full target dividend immediately instead of applying the partial adjustment factor.

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

Question 6 · 2 marks · Dividend Decisions · medium

If SCCL's EPS rises to ₹24.00 next year and it continues with the same target payout ratio of 50% and adjustment factor of 0.30, what will be next year's dividend per share?

1. ₹8.15 (correct answer)
2. ₹7.50
3. ₹8.00
4. ₹9.00

Answer: A — ₹8.15

Explanation. Step 1: Target dividend next year = ₹24.00 × 50% = ₹12.00. Step 2: D2 = D1 + c × (Target DPS2 − D1) = 6.50 + 0.30 × (12.00 − 6.50) = 6.50 + 1.65 = ₹8.15. Option (c) ₹8.00 is a rounded figure from applying c = 0.25; option (d) ₹9.00 results from using D0 instead of D1 as the base.

Where it goes wrong. Using last year's dividend (₹5.00) instead of the current year's dividend (₹6.50) as the base for next year's smoothing calculation.

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

Question 7 · 2 marks · Dividend Decisions · medium

What adjustment factor would SCCL need in the current year to pay a dividend of ₹8.00 per share, given D0 = ₹5.00, EPS1 = ₹20.00 and a target payout ratio of 50%?

1. 0.30
2. 0.50
3. 0.60 (correct answer)
4. 0.75

Answer: C — 0.60

Explanation. Target DPS = ₹20.00 × 50% = ₹10.00. Lintner's model: 8.00 = 5.00 + c × (10.00 − 5.00). Therefore, 3.00 = 5.00c, giving c = 0.60. Option (b) 0.50 would produce D1 = 5.00 + 0.50 × 5.00 = ₹7.50, which is below the desired ₹8.00. Option (d) 0.75 would overshoot to ₹8.75.

Where it goes wrong. Dividing the desired increase (₹3.00) by the target dividend (₹10.00) instead of by the gap between target and last dividend (₹5.00).

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

Question 8 · 2 marks · Dividend Decisions · medium

If SCCL raises its target payout ratio to 60% while keeping D0 = ₹5.00, EPS1 = ₹20.00 and the adjustment factor at 0.30, what will be the current year's dividend per share?

1. ₹6.50
2. ₹7.10 (correct answer)
3. ₹7.50
4. ₹8.00

Answer: B — ₹7.10

Explanation. New target dividend = ₹20.00 × 60% = ₹12.00. D1 = 5.00 + 0.30 × (12.00 − 5.00) = 5.00 + 2.10 = ₹7.10. Option (a) ₹6.50 is the dividend under the original 50% target; option (d) ₹8.00 would require an adjustment factor of about 0.43, not 0.30.

Where it goes wrong. Applying the 60% target to last year's dividend or to the increase rather than to current EPS.

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

Question 9 · 2 marks · Dividend Decisions · medium

Scenario. A company has just paid a dividend of ₹4.00 per share. Its dividends are expected to grow at 5% per annum indefinitely and the cost of equity is 13%. What is the current market price per share under Gordon's growth model?

A company has just paid a dividend of ₹4.00 per share. Its dividends are expected to grow at 5% per annum indefinitely and the cost of equity is 13%. What is the current market price per share under Gordon's growth model?

1. ₹50.00
2. ₹52.50 (correct answer)
3. ₹55.00
4. ₹48.00

Answer: B — ₹52.50

Explanation. Gordon's model uses the next expected dividend: D1 = D0 × (1 + g) = 4.00 × 1.05 = ₹4.20. P0 = D1 ÷ (Ke − g) = 4.20 ÷ (0.13 − 0.05) = 4.20 ÷ 0.08 = ₹52.50. Option (a) ₹50.00 uses the current dividend D0 = ₹4.00 instead of D1; option (d) ₹48.00 wrongly subtracts growth from the dividend.

Where it goes wrong. Using D0 instead of D1 in the numerator of Gordon's constant-growth formula.

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

Question 10 · 2 marks · Dividend Decisions · medium

Scenario. A share is currently quoted at ₹75. It is expected to pay a dividend of ₹6.00 next year, and dividends are expected to grow at 4% per annum indefinitely. What is the implied cost of equity?

A share is currently quoted at ₹75. It is expected to pay a dividend of ₹6.00 next year, and dividends are expected to grow at 4% per annum indefinitely. What is the implied cost of equity?

1. 10%
2. 11%
3. 12% (correct answer)
4. 13%

Answer: C — 12%

Explanation. Under Gordon's model, P0 = D1 ÷ (Ke − g), which rearranges to Ke = D1/P0 + g. Ke = 6.00 ÷ 75.00 + 4% = 8% + 4% = 12%. Option (a) 10% ignores the growth component; option (b) 11% uses a growth rate of 3% instead of 4%.

Where it goes wrong. Forgetting to add the growth rate to the dividend yield when deriving the implied cost of equity.

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

Question 11 · 2 marks · Dividend Decisions · medium

Scenario. A company has expected EPS of ₹10.00, a retention ratio of 60%, an internal rate of return of 10% and a cost of equity of 14%. What is its market price per share under Gordon's model?

A company has expected EPS of ₹10.00, a retention ratio of 60%, an internal rate of return of 10% and a cost of equity of 14%. What is its market price per share under Gordon's model?

1. ₹40.00
2. ₹60.00
3. ₹75.00
4. ₹50.00 (correct answer)

Answer: D — ₹50.00

Explanation. Step 1: g = b × r = 0.60 × 10% = 6%. Step 2: D1 = E1 × (1 − b) = 10.00 × 0.40 = ₹4.00. Step 3: P0 = 4.00 ÷ (0.14 − 0.06) = 4.00 ÷ 0.08 = ₹50.00. Option (b) ₹60.00 uses D1 = ₹4.80, which wrongly applies a 52% payout; option (a) ₹40.00 uses a denominator of 0.10.

Where it goes wrong. Computing D1 as EPS × retention ratio instead of EPS × payout ratio.

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

Question 12 · 2 marks · Dividend Decisions · medium

Scenario. A firm has expected EPS of ₹12.00, an internal rate of return of 10% and a cost of equity of 15%. What is its market price per share under Gordon's model if it retains 30% of earnings?

A firm has expected EPS of ₹12.00, an internal rate of return of 10% and a cost of equity of 15%. What is its market price per share under Gordon's model if it retains 30% of earnings?

1. ₹70.00 (correct answer)
2. ₹60.00
3. ₹75.00
4. ₹80.00

Answer: A — ₹70.00

Explanation. Step 1: g = 0.30 × 10% = 3%. Step 2: D1 = ₹12.00 × 0.70 = ₹8.40. Step 3: P0 = 8.40 ÷ (0.15 − 0.03) = 8.40 ÷ 0.12 = ₹70.00. Option (b) ₹60.00 is the price at a 50% retention ratio; option (c) ₹75.00 would require a growth rate of 3.8%.

Where it goes wrong. Using the retention ratio as the payout ratio, or applying g = b × Ke instead of b × r.

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

Question 13 · 2 marks · Dividend Decisions · medium

Scenario. A company paid a dividend of ₹8.00 per share last year. Its current EPS is ₹25.00, the target payout ratio is 40% and the adjustment factor is 0.50. Under Lintner's model, what is the current year's dividend per share?

A company paid a dividend of ₹8.00 per share last year. Its current EPS is ₹25.00, the target payout ratio is 40% and the adjustment factor is 0.50. Under Lintner's model, what is the current year's dividend per share?

1. ₹8.00
2. ₹8.50
3. ₹9.50
4. ₹9.00 (correct answer)

Answer: D — ₹9.00

Explanation. Target DPS = ₹25.00 × 40% = ₹10.00. D1 = D0 + c × (Target DPS − D0) = 8.00 + 0.50 × (10.00 − 8.00) = 8.00 + 1.00 = ₹9.00. Option (b) ₹8.50 uses c = 0.25; option (c) ₹9.50 uses a target payout of 60% instead of 40%.

Where it goes wrong. Applying the adjustment factor to EPS instead of to the gap between the target DPS and last year's DPS.

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

Question 14 · 2 marks · Dividend Decisions · medium

Scenario. A company paid ₹4.00 as dividend last year and plans to pay ₹5.00 this year. Its target payout ratio is 50% and the adjustment factor is 0.25. What is the current EPS implied by Lintner's model?

A company paid ₹4.00 as dividend last year and plans to pay ₹5.00 this year. Its target payout ratio is 50% and the adjustment factor is 0.25. What is the current EPS implied by Lintner's model?

1. ₹12.00
2. ₹14.00
3. ₹15.00
4. ₹16.00 (correct answer)

Answer: D — ₹16.00

Explanation. Lintner's model: D1 = D0 + c × (EPS × target payout − D0). Substituting, 5.00 = 4.00 + 0.25 × (0.50 × EPS − 4.00). Therefore, 1.00 = 0.25 × (0.50 EPS − 4.00), so 4.00 = 0.50 EPS − 4.00 and 0.50 EPS = 8.00, giving EPS = ₹16.00. Option (c) ₹15.00 results from using a 60% target payout.

Where it goes wrong. Dividing the desired dividend increase by the target payout ratio without solving the full Lintner equation.

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

Question 15 · 2 marks · Dividend Decisions · medium

Scenario. A company paid ₹6.00 as dividend last year. Its current EPS is ₹20.00, the target payout ratio is 60% and the proposed current dividend is ₹9.00. What adjustment factor is implied by Lintner's model?

A company paid ₹6.00 as dividend last year. Its current EPS is ₹20.00, the target payout ratio is 60% and the proposed current dividend is ₹9.00. What adjustment factor is implied by Lintner's model?

1. 0.25
2. 0.30
3. 0.40
4. 0.50 (correct answer)

Answer: D — 0.50

Explanation. Target DPS = ₹20.00 × 60% = ₹12.00. Lintner's model: 9.00 = 6.00 + c × (12.00 − 6.00). Therefore, 3.00 = 6.00c, giving c = 0.50. Option (b) 0.30 would produce D1 = ₹7.80; option (c) 0.40 would produce ₹8.40, both below the proposed ₹9.00.

Where it goes wrong. Dividing the increase in dividend (₹3.00) by the target DPS (₹12.00) instead of by the target-minus-last-dividend gap (₹6.00).

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

Question 16 · 2 marks · Dividend Decisions · medium

Scenario. Under Gordon's dividend model, what is the optimal dividend payout ratio for a declining firm where the internal rate of return is lower than the cost of equity?

Under Gordon's dividend model, what is the optimal dividend payout ratio for a declining firm where the internal rate of return is lower than the cost of equity?

1. 0% payout
2. 50% payout
3. 100 percent payout (correct answer)
4. Any payout ratio is equally optimal

Answer: C — 100 percent payout

Explanation. When r < Ke, retained earnings earn less than shareholders' required return, so every rupee retained destroys value. Distributing all earnings as dividends is therefore optimal, giving a 100 percent payout ratio. A 0% payout is optimal only for a growth firm where r > Ke; indifference applies only when r = Ke.

Where it goes wrong. Applying the growth-firm rule (0% payout) to a declining firm, or assuming payout is irrelevant unless r = Ke.

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

Question 17 · 2 marks · Dividend Decisions · medium

Scenario. A company has expected EPS of ₹9.00. Its internal rate of return and cost of equity are both 12%. What is its market price per share under Gordon's model, regardless of its retention ratio?

A company has expected EPS of ₹9.00. Its internal rate of return and cost of equity are both 12%. What is its market price per share under Gordon's model, regardless of its retention ratio?

1. ₹60.00
2. ₹75.00 (correct answer)
3. ₹90.00
4. ₹100.00

Answer: B — ₹75.00

Explanation. When r = Ke, Gordon's formula collapses to P0 = E1 ÷ Ke regardless of b. Here P0 = 9.00 ÷ 0.12 = ₹75.00. At b = 0, D1 = ₹9.00, g = 0 and P0 = 9.00 ÷ 0.12 = ₹75.00; at b = 0.50, D1 = ₹4.50, g = 6% and P0 = 4.50 ÷ 0.06 = ₹75.00. Option (c) ₹90.00 wrongly uses Ke = 10%.

Where it goes wrong. Assuming the retention ratio still affects price when r = Ke, or using EPS × (1 − b) without adjusting the denominator for g.

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

Question 18 · 2 marks · Dividend Decisions · medium

Scenario. A share is currently priced at ₹60. It is expected to pay a dividend of ₹3.00 next year, and dividends are expected to grow at 6% per annum indefinitely. What is the expected capital gain yield?

A share is currently priced at ₹60. It is expected to pay a dividend of ₹3.00 next year, and dividends are expected to grow at 6% per annum indefinitely. What is the expected capital gain yield?

1. 5%
2. 8%
3. 11%
4. 6% (correct answer)

Answer: D — 6%

Explanation. Under Gordon's constant-growth model, the capital gain yield equals the growth rate g, which is 6%. For verification, Ke = D1/P0 + g = 3.00/60.00 + 6% = 5% + 6% = 11%. The dividend yield is 5% and the capital gain yield is 6%. Option (c) 11% is the total cost of equity, not the capital gain yield.

Where it goes wrong. Reporting the total required return (Ke) instead of the capital gain component (g).

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

Question 19 · 2 marks · Dividend Decisions · medium

Scenario. A company paid ₹10.00 as dividend last year. Its current EPS is ₹30.00, the target payout ratio is 50% and the adjustment factor is 0.40. Under Lintner's model, what is the current year's dividend per share?

A company paid ₹10.00 as dividend last year. Its current EPS is ₹30.00, the target payout ratio is 50% and the adjustment factor is 0.40. Under Lintner's model, what is the current year's dividend per share?

1. ₹10.00
2. ₹11.00
3. ₹12.00 (correct answer)
4. ₹13.00

Answer: C — ₹12.00

Explanation. Target DPS = ₹30.00 × 50% = ₹15.00. D1 = 10.00 + 0.40 × (15.00 − 10.00) = 10.00 + 2.00 = ₹12.00. Option (b) ₹11.00 uses c = 0.20; option (d) ₹13.00 uses a target payout of 60%, which would give a target DPS of ₹18.00.

Where it goes wrong. Applying the adjustment factor to the full target dividend instead of only to the gap between target and last year's dividend.

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

Question 20 · 2 marks · Dividend Decisions · medium

Scenario. A company paid a dividend of ₹5.00 per share last year. Dividends are expected to grow at 8% per annum indefinitely and the cost of equity is 12%. What is the current market price per share under Gordon's growth model?

A company paid a dividend of ₹5.00 per share last year. Dividends are expected to grow at 8% per annum indefinitely and the cost of equity is 12%. What is the current market price per share under Gordon's growth model?

1. ₹135.00 (correct answer)
2. ₹125.00
3. ₹130.00
4. ₹140.00

Answer: A — ₹135.00

Explanation. D1 = D0 × (1 + g) = ₹5.00 × 1.08 = ₹5.40. P0 = D1 ÷ (Ke − g) = 5.40 ÷ (0.12 − 0.08) = 5.40 ÷ 0.04 = ₹135.00. Option (b) ₹125.00 uses the current dividend ₹5.00 without growth; option (c) ₹130.00 uses a growth rate of 7.5%.

Where it goes wrong. Using D0 instead of D1 in Gordon's formula, which understates the price by exactly the growth factor.

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