Answer to Question #199880 in Finance for Kaju

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

a. Price of the share using Walter Model is:

$P = (0.6×50 + 0.15/0.11×50×(1 - 0.6))/0.11 = 520.66.$

The cost of capital is lower than the return on investment, so dividend is to be declared.

b. Price of the share using Gordon model is:

$P = 50×0.6/(0.15 - 0.11) = 750.$

The cost of capital is lower than the return on investment, so dividend is to be declared.