Answer to Question #314805 in Management for Vineet Singh

Question

The equity shares of a publicly traded company are priced at Rs. 450 with P/E (Price to Earnings) ratio of 15. The announces a dividend of Rs. 9 per shares. The shareholders of the company expect the dividend to grow at a rate of 6% every year, and the cost of equity for the company is 15%. According to the dividend relevance approach suggested by Walter and Gordon, what would be the impact of dividend announcement on the market price of the shares of the company if required rate of return for investors is (i) 12%, (ii) 15% and (iii) 18%.

Answer 1

Investment decision: If V0> Current Market Price --- Buy

V0 < Price Don’t buy, ---Sell if already holding

Solution: D1= 4, Ke =.18, and P1= 92

V0 = (4+92)/(1+.18)

= 81.35 ; Current market price =Rs. 80

Decision: Since V0 > Market Price investor should buy the share.

(2) Multi year holding period

V0 = D1/(1+Ke) + D2 /(1+Ke)+...........+Pn/ (1+Ke)

D1 = Expected dividends at the end of one year,

D2 = Expected dividends at the end of 2nd year,

Pn = Expected price of share at the end of nth year

Ke = Investor’s required rate of return