Test 3: Dividend Decisions: answer key

Question 1 · 2 marks · Dividend Decisions · medium

Scenario. Suryodaya Power Ltd. (SPL) is an all-equity company with 10,00,000 fully paid equity shares of ₹10 each. The current market price per share is ₹100 and the cost of equity (Ke) is 10%. The company expects net income (E) of ₹1,10,00,000 for the current year and has an approved investment budget (I) of ₹2,20,00,000. SPL is considering declaring a dividend of ₹10 per share. The company follows the Modigliani-Miller (MM) dividend irrelevance framework and has no debt. The finance team is evaluating the impact of the dividend decision on the market price per share at the end of the year (P1), the number of new shares to be issued (Δn) to finance the investment, and the total value of the firm under both dividend-paid and no-dividend scenarios. Key financial data: Particulars | Amount Outstanding equity shares (n) | 10,00,000 Current market price (P0) | ₹100 Cost of equity (Ke) | 10% Expected net income (E) | ₹1,10,00,000 Investment budget (I) | ₹2,20,00,000 Proposed dividend (D1) | ₹10 per share The company has no retained earnings brought forward and all investment is financed by equity. The MM assumptions of perfect capital markets, no taxes, no flotation costs and fixed investment policy hold.

If Suryodaya Power Ltd. declares a dividend of ₹10 per share, what will be the market price per share at the end of the year (P1) under the MM framework?

1. ₹110
2. ₹90
3. ₹100 (correct answer)
4. ₹105

Answer: C — ₹100

Explanation. MM valuation: P0 = (P1 + D1) ÷ (1 + Ke). Substituting, 100 = (P1 + 10) ÷ 1.10 → P1 + 10 = 110 → P1 = ₹100. Option (a) ₹110 is the price when no dividend is paid (P1 = 110), and option (d) ₹105 arises if Ke is taken as 5% instead of 10%.

Where it goes wrong. Using the no-dividend price (₹110) or incorrectly solving for P1 without multiplying P0 by (1 + Ke).

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

Question 2 · 2 marks · Dividend Decisions · medium

If SPL pays the dividend of ₹10 per share, what is the number of new shares (Δn) that must be issued to finance the investment budget?

1. 1,00,000 shares
2. 2,00,000 shares
3. 2,20,000 shares
4. 2,10,000 shares (correct answer)

Answer: D — 2,10,000 shares

Explanation. Retained earnings = E − nD1 = 1,10,00,000 − (10,00,000 × 10) = 1,10,00,000 − 1,00,00,000 = ₹10,00,000. Funds required = I − Retained earnings = 2,20,00,000 − 10,00,000 = ₹2,10,00,000. Δn = Funds required ÷ P1 = 2,10,00,000 ÷ 100 = 2,10,000 shares. Option (b) 2,00,000 ignores the ₹10,00,000 retained earnings, and option (a) 1,00,000 is the number of new shares when no dividend is paid.

Where it goes wrong. Forgetting to deduct retained earnings (E − nD1) from the investment budget before dividing by P1.

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

Question 3 · 2 marks · Dividend Decisions · medium

What is the total value of Suryodaya Power Ltd. if it pays the dividend of ₹10 per share, as per the MM valuation equation?

1. ₹11,00,00,000
2. ₹10,00,00,000 (correct answer)
3. ₹9,00,00,000
4. ₹10,50,00,000

Answer: B — ₹10,00,00,000

Explanation. Value of firm = [(n + Δn)P1 − I + E] ÷ (1 + Ke) = [(10,00,000 + 2,10,000) × 100 − 2,20,00,000 + 1,10,00,000] ÷ 1.10 = [12,10,00,000 − 1,10,00,000] ÷ 1.10 = 11,00,00,000 ÷ 1.10 = ₹10,00,00,000. This equals n × P0 = 10,00,000 × 100 = ₹10,00,00,000, confirming MM irrelevance. Option (a) ₹11,00,00,000 is the undiscounted numerator.

Where it goes wrong. Omitting the discounting by (1 + Ke) or incorrectly adding I and E instead of subtracting I and adding E.

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

Question 4 · 2 marks · Dividend Decisions · medium

If SPL does not pay any dividend, what is the number of new shares it must issue to finance the investment budget?

1. 1,00,000 shares (correct answer)
2. 2,10,000 shares
3. 90,909 shares
4. 1,10,000 shares

Answer: A — 1,00,000 shares

Explanation. With no dividend, the entire net income is retained: Retained earnings = ₹1,10,00,000. Funds required = I − E = 2,20,00,000 − 1,10,00,000 = ₹1,10,00,000. P1 with no dividend = P0(1 + Ke) = 100 × 1.10 = ₹110. Δn = 1,10,00,000 ÷ 110 = 1,00,000 shares. Option (c) 90,909 uses P1 = ₹121 or a different Ke.

Where it goes wrong. Using the dividend-paid P1 of ₹100 instead of the no-dividend P1 of ₹110 when computing Δn.

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

Question 5 · 2 marks · Dividend Decisions · medium

Scenario. Kaveri Motors Ltd. (KML) has an equity share capital of ₹5,00,00,000 comprising 50,00,000 shares of ₹10 each. It has free reserves of ₹2,00,00,000 and securities premium of ₹50,00,000. The company earned a profit after tax of ₹1,50,00,000 during the year and has a cash balance of ₹80,00,000. The Board is considering three alternative proposals: (i) declare a cash dividend of ₹3 per share; (ii) issue bonus shares in the ratio 1:5 (one bonus share for every five shares held); or (iii) buy back 5,00,000 shares at ₹30 per share. The company has no partly paid shares and has not defaulted in repayment of any loan or interest. The market price per share before any dividend or buyback is ₹30. Key financial data: Particulars | Amount Equity share capital (50,00,000 shares of ₹10) | ₹5,00,00,000 Free reserves | ₹2,00,00,000 Securities premium | ₹50,00,000 Profit after tax | ₹1,50,00,000 Cash balance | ₹80,00,000 Proposed cash dividend | ₹3 per share Proposed bonus ratio | 1:5 Proposed buyback | 5,00,000 shares at ₹30 KML is evaluating the legal restrictions under Section 123 of the Companies Act, 2013, the impact of the bonus issue on EPS, and the equivalence of cash dividend and share buyback under the MM framework.

Under Section 123 of the Companies Act, 2013, which of the following is NOT a valid source for declaration of dividend by Kaveri Motors Ltd.?

1. Profits of the current year after providing depreciation
2. Undistributed profits of previous years after providing depreciation
3. Revaluation reserves arising from revaluation of fixed assets (correct answer)
4. Money provided by the Central Government or a State Government

Answer: C — Revaluation reserves arising from revaluation of fixed assets

Explanation. Section 123 permits dividend out of current year profits, accumulated profits of previous years (after depreciation), or government money provided under a guarantee. It expressly excludes unrealised gains, notional gains and revaluation of assets. Therefore, revaluation reserves cannot be used for dividend. Option (a) and (b) are expressly permitted sources under Section 123(1).

Where it goes wrong. Confusing free reserves (which can be used) with revaluation reserves (which cannot) under Section 123.

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

Question 6 · 2 marks · Dividend Decisions · medium

If Kaveri Motors Ltd. issues bonus shares in the ratio 1:5, what amount must be transferred from free reserves and/or securities premium to equity share capital?

1. ₹50,00,000
2. ₹2,00,00,000
3. ₹1,50,00,000
4. ₹1,00,00,000 (correct answer)

Answer: D — ₹1,00,00,000

Explanation. Bonus ratio 1:5 on 50,00,000 shares = 10,00,000 bonus shares. Each bonus share has a face value of ₹10. Amount to be capitalised = 10,00,000 × ₹10 = ₹1,00,00,000. Option (a) ₹50,00,000 is a 1:10 bonus; option (c) ₹1,50,00,000 is the proposed cash dividend amount, not the bonus capitalisation.

Where it goes wrong. Computing the bonus amount on the market price (₹30) instead of the face value (₹10) of the bonus shares.

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

Question 7 · 2 marks · Dividend Decisions · medium

What will be the Earnings Per Share (EPS) of Kaveri Motors Ltd. immediately after the 1:5 bonus issue, assuming profit after tax remains ₹1,50,00,000?

1. ₹3.00
2. ₹2.50 (correct answer)
3. ₹2.00
4. ₹3.33

Answer: B — ₹2.50

Explanation. Existing shares = 50,00,000. Bonus shares = 10,00,000. Total shares after bonus = 60,00,000. EPS = PAT ÷ total shares = 1,50,00,000 ÷ 60,00,000 = ₹2.50. Option (a) ₹3.00 is the pre-bonus EPS (1,50,00,000 ÷ 50,00,000), and option (d) ₹3.33 is the post-buyback EPS, not the post-bonus EPS.

Where it goes wrong. Dividing PAT by the original number of shares (50,00,000) instead of the post-bonus number (60,00,000).

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

Question 8 · 2 marks · Dividend Decisions · medium

A shareholder of Kaveri Motors Ltd. holds 100 shares. To replicate the cash dividend of ₹3 per share through the buyback route at ₹30 per share, how many shares must the shareholder sell?

1. 10 shares (correct answer)
2. 5 shares
3. 15 shares
4. 20 shares

Answer: A — 10 shares

Explanation. Under the dividend option, the shareholder receives 100 × ₹3 = ₹300 cash. Under the buyback, shares are repurchased at ₹30 each. Number of shares to sell = ₹300 ÷ ₹30 = 10 shares. The shareholder is left with 90 shares valued at ₹30 each (₹2,700) plus ₹300 cash, totalling ₹3,000 — the same as under the dividend option (100 shares × ₹27 ex-dividend + ₹300 cash). Option (b) 5 shares would yield only ₹150 cash.

Where it goes wrong. Dividing the total dividend by the pre-buyback market price (₹30) correctly, but then choosing the wrong number from the options due to arithmetic error.

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

Question 9 · 2 marks · Dividend Decisions · medium

Scenario. A company has a current market price (P0) of ₹100, a cost of equity (Ke) of 10% and is expected to pay a dividend of ₹5 per share. Under the MM framework, what is the expected price at the end of the year (P1)?

A company has a current market price (P0) of ₹100, a cost of equity (Ke) of 10% and is expected to pay a dividend of ₹5 per share. Under the MM framework, what is the expected price at the end of the year (P1)?

1. ₹100
2. ₹110
3. ₹105 (correct answer)
4. ₹95

Answer: C — ₹105

Explanation. MM valuation: P0 = (P1 + D1) ÷ (1 + Ke). Substituting, 100 = (P1 + 5) ÷ 1.10 → P1 + 5 = 110 → P1 = ₹105. Option (b) ₹110 is the no-dividend price, and option (d) ₹95 incorrectly subtracts the dividend from P0 instead of adding it to P1.

Where it goes wrong. Subtracting the dividend from P0 (100 − 5 = 95) instead of solving the MM equation for P1.

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

Question 10 · 2 marks · Dividend Decisions · medium

Scenario. A firm has 1,00,000 outstanding shares, current market price ₹100, cost of equity 10%, expected net income ₹50,00,000 and an investment budget of ₹55,50,000. If it pays a dividend of ₹5 per share, how many new shares must be issued?

A firm has 1,00,000 outstanding shares, current market price ₹100, cost of equity 10%, expected net income ₹50,00,000 and an investment budget of ₹55,50,000. If it pays a dividend of ₹5 per share, how many new shares must be issued?

1. 15,000 shares
2. 5,000 shares
3. 12,000 shares
4. 10,000 shares (correct answer)

Answer: D — 10,000 shares

Explanation. P1 = 100 × 1.10 − 5 = ₹105. Retained earnings = 50,00,000 − (1,00,000 × 5) = ₹45,00,000. Funds required = 55,50,000 − 45,00,000 = ₹10,50,000. Δn = 10,50,000 ÷ 105 = 10,000 shares. Option (b) 5,000 is the number of new shares if no dividend is paid (funds required = 5,50,000 ÷ 110 = 5,000).

Where it goes wrong. Using the no-dividend P1 of ₹110, or failing to deduct the dividend paid from net income before computing funds required.

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

Question 11 · 2 marks · Dividend Decisions · medium

Scenario. For the same firm as in the previous question (n = 1,00,000, P0 = ₹100, Ke = 10%, E = ₹50,00,000, I = ₹55,50,000, D1 = ₹5), what is the value of the firm if the dividend is paid?

For the same firm as in the previous question (n = 1,00,000, P0 = ₹100, Ke = 10%, E = ₹50,00,000, I = ₹55,50,000, D1 = ₹5), what is the value of the firm if the dividend is paid?

1. ₹1,10,00,000
2. ₹1,00,00,000 (correct answer)
3. ₹90,00,000
4. ₹1,05,00,000

Answer: B — ₹1,00,00,000

Explanation. Δn = 10,000 shares and P1 = ₹105. Value = [(n + Δn)P1 − I + E] ÷ (1 + Ke) = [(1,00,000 + 10,000) × 105 − 55,50,000 + 50,00,000] ÷ 1.10 = [1,15,50,000 − 5,50,000] ÷ 1.10 = 1,10,00,000 ÷ 1.10 = ₹1,00,00,000. This equals nP0 = 1,00,000 × 100 = ₹1,00,00,000, verifying MM irrelevance.

Where it goes wrong. Forgetting to add back E or to subtract I in the numerator, or dividing by (1 + Ke) incorrectly.

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

Question 12 · 2 marks · Dividend Decisions · medium

Scenario. Which of the following is NOT an assumption of the Modigliani-Miller dividend irrelevance hypothesis?

Which of the following is NOT an assumption of the Modigliani-Miller dividend irrelevance hypothesis?

1. Perfect capital markets with freely available information
2. No taxes or tax discrimination between dividends and capital gains
3. Fixed investment policy financed entirely by equity
4. Risk and uncertainty exist and investors cannot forecast future prices (correct answer)

Answer: D — Risk and uncertainty exist and investors cannot forecast future prices

Explanation. MM assumes perfect capital markets, no taxes, a fixed investment policy, no flotation or transaction costs, and that risk and uncertainty do not exist — investors can forecast future prices and dividends with certainty. Option (d) directly contradicts the certainty assumption. Options (a), (b) and (c) are explicitly listed MM assumptions.

Where it goes wrong. Confusing the realistic presence of risk and uncertainty in actual markets with the MM assumption that certainty prevails.

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

Question 13 · 2 marks · Dividend Decisions · medium

Scenario. Which of the following is a major limitation of the MM dividend irrelevance hypothesis?

Which of the following is a major limitation of the MM dividend irrelevance hypothesis?

1. It relies on the arbitrage process to prove irrelevance
2. It assumes that investors can create home-made dividends
3. It assumes a fixed investment policy and no flotation costs
4. Its assumptions of perfect markets, no taxes and certainty are unrealistic (correct answer)

Answer: D — Its assumptions of perfect markets, no taxes and certainty are unrealistic

Explanation. The MM hypothesis is logically consistent and uses arbitrage effectively, but its assumptions — perfect capital markets, no taxes, no flotation costs, fixed investment policy and certainty — are unrealistic in the real world. Options (a), (b) and (c) are features or assumptions of the model, not limitations. Hence, the unrealistic assumptions are the principal limitation.

Where it goes wrong. Identifying a feature of the MM model (arbitrage, home-made dividends) as a limitation instead of the unrealistic assumptions.

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

Question 14 · 2 marks · Dividend Decisions · medium

Scenario. A firm has 1,00,000 shares, current market price ₹100, Ke 10%, net income ₹50,00,000 and investment budget ₹55,50,000. If the firm does not pay any dividend, how many new shares must it issue?

A firm has 1,00,000 shares, current market price ₹100, Ke 10%, net income ₹50,00,000 and investment budget ₹55,50,000. If the firm does not pay any dividend, how many new shares must it issue?

1. 5,000 shares (correct answer)
2. 10,000 shares
3. 15,000 shares
4. 20,000 shares

Answer: A — 5,000 shares

Explanation. With no dividend, retained earnings = ₹50,00,000. Funds required = 55,50,000 − 50,00,000 = ₹5,50,000. P1 = 100 × 1.10 = ₹110. Δn = 5,50,000 ÷ 110 = 5,000 shares. Option (b) 10,000 is the number of new shares when a dividend of ₹5 is paid, not when no dividend is paid.

Where it goes wrong. Using the dividend-paid P1 of ₹105 instead of the no-dividend P1 of ₹110 when computing the number of new shares.

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

Question 15 · 2 marks · Dividend Decisions · medium

Scenario. Under Section 123 of the Companies Act, 2013, which of the following is NOT a valid condition or source for declaration of dividend?

Under Section 123 of the Companies Act, 2013, which of the following is NOT a valid condition or source for declaration of dividend?

1. Depreciation must be provided before declaring dividend out of current year profits
2. A company that has defaulted in repayment of a loan to a financial institution cannot declare dividend
3. Dividend can be declared out of revaluation reserves arising from revaluation of fixed assets (correct answer)
4. Dividend can be declared out of undistributed profits of previous years after providing depreciation

Answer: C — Dividend can be declared out of revaluation reserves arising from revaluation of fixed assets

Explanation. Section 123 expressly excludes unrealised gains, notional gains and revaluation of assets from the computation of profits for dividend. Therefore, revaluation reserves cannot be used. Options (a), (b) and (d) are valid conditions: depreciation must be provided, default in loan repayment bars dividend, and accumulated profits after depreciation are a permitted source.

Where it goes wrong. Assuming that any reserve (including revaluation reserves) can be used for dividend, whereas Section 123 specifically prohibits revaluation reserves.

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

Question 16 · 2 marks · Dividend Decisions · medium

Scenario. A company has 1,00,000 equity shares of ₹10 each, free reserves of ₹8,00,000 and securities premium of ₹2,00,000. It issues bonus shares in the ratio 1:2. What amount must be transferred from free reserves and/or securities premium to equity share capital?

A company has 1,00,000 equity shares of ₹10 each, free reserves of ₹8,00,000 and securities premium of ₹2,00,000. It issues bonus shares in the ratio 1:2. What amount must be transferred from free reserves and/or securities premium to equity share capital?

1. ₹2,50,000
2. ₹5,00,000 (correct answer)
3. ₹7,50,000
4. ₹10,00,000

Answer: B — ₹5,00,000

Explanation. Bonus ratio 1:2 on 1,00,000 shares = 50,000 bonus shares. Face value per share = ₹10. Amount to be capitalised = 50,000 × ₹10 = ₹5,00,000. Option (a) ₹2,50,000 is a 1:4 bonus; option (d) ₹10,00,000 is a 1:1 bonus. The available free reserves and securities premium (₹10,00,000) are sufficient to fund the ₹5,00,000 capitalisation.

Where it goes wrong. Computing the bonus amount on the market price or on the total reserves instead of on the face value of the bonus shares.

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

Question 17 · 2 marks · Dividend Decisions · medium

Scenario. A company splits each equity share of face value ₹100 into four shares of face value ₹25. What is the percentage increase in the number of outstanding shares?

A company splits each equity share of face value ₹100 into four shares of face value ₹25. What is the percentage increase in the number of outstanding shares?

1. full
2. 200%
3. 300% (correct answer)
4. 400%

Answer: C — 300%

Explanation. One share becomes four shares, so the number of shares increases from 1 to 4, i.e. an increase of 3 shares for every 1 original share. Percentage increase = (3 ÷ 1) × 100 = 300%. Option (a) full is the percentage increase in the number of shares if one share splits into two (a 2-for-1 split), not four.

Where it goes wrong. Reporting the final multiple (4 times) as a percentage increase (400%) instead of the increase over the original number (300%).

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

Question 18 · 2 marks · Dividend Decisions · medium

Scenario. A company has 1,00,000 outstanding shares, profit after tax of ₹10,00,000 and a P/E ratio of 10. It buys back 20,000 shares at the prevailing market price. Assuming PAT remains unchanged, what is the EPS after the buyback?

A company has 1,00,000 outstanding shares, profit after tax of ₹10,00,000 and a P/E ratio of 10. It buys back 20,000 shares at the prevailing market price. Assuming PAT remains unchanged, what is the EPS after the buyback?

1. ₹10.00
2. ₹12.50 (correct answer)
3. ₹15.00
4. ₹8.00

Answer: B — ₹12.50

Explanation. Current EPS = 10,00,000 ÷ 1,00,000 = ₹10. Market price = EPS × P/E = 10 × 10 = ₹100. Shares after buyback = 1,00,000 − 20,000 = 80,000. New EPS = 10,00,000 ÷ 80,000 = ₹12.50. Option (a) ₹10.00 is the pre-buyback EPS, and option (c) ₹15.00 would require a buyback of 33,333 shares.

Where it goes wrong. Forgetting to reduce the number of shares after buyback, or using the buyback price (₹100) instead of PAT to compute the new EPS.

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

Question 19 · 2 marks · Dividend Decisions · medium

Scenario. Under the MM framework, a shareholder can create a 'home-made dividend' by:

Under the MM framework, a shareholder can create a 'home-made dividend' by:

1. Selling a part of his shareholding in the market (correct answer)
2. Buying additional shares from the market
3. Receiving bonus shares from the company
4. Reinvesting the dividend received in the company's shares

Answer: A — Selling a part of his shareholding in the market

Explanation. A home-made dividend is cash created by an investor by selling a portion of his shares when the company does not pay a dividend. The investor receives cash (capital receipt) but suffers an equal capital loss due to dilution of ownership, so total wealth remains unchanged. Option (b) buying shares requires cash outflow; option (c) bonus shares are not cash; option (d) reinvestment is not a dividend.

Where it goes wrong. Confusing a home-made dividend (selling shares) with a bonus issue or with reinvestment of an actual dividend.

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

Question 20 · 2 marks · Dividend Decisions · medium

Scenario. The MM dividend irrelevance hypothesis proves that dividend policy does not affect firm value primarily through:

The MM dividend irrelevance hypothesis proves that dividend policy does not affect firm value primarily through:

1. The arbitrage process (correct answer)
2. The tax differential between dividends and capital gains
3. The flotation costs of new issues
4. The bird-in-hand argument

Answer: A — The arbitrage process

Explanation. MM demonstrates that any investor who prefers a different dividend stream can undo the firm's dividend decision through the arbitrage process — selling shares to create home-made dividends or buying shares with unwanted dividends. This arbitrage ensures that the total value of the firm remains unchanged. Option (b) contradicts the no-tax assumption; option (c) contradicts the no-flotation-cost assumption; option (d) is Gordon's argument, not MM's.

Where it goes wrong. Attributing the proof to taxes, flotation costs or the bird-in-hand theory, all of which are either assumed away or belong to competing models.

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