Question

Company X earns 6 TL per share. If the discount rate or equity cost to be applied by the company is 20% and the investment profitability is 16%;

 a) According to Walter formula, what would be the price of the shares if the business had distributed 50% profit?

b) Is this the optimum dividend distribution rate, according to Walter? Explain

Answer 1

a) Walters formula is as follows

 Price of shares as per Walter formula : = [D + (r / Ke)(E - D)] / Ke where,

E = Earnings per share = 6 TL

D = Dividend per share = Earnings x payout% = 6 TL x 0.50 = 3 TL

r = internal rate of return = 0.16

Ke = Cost of Equity = 0.20

Hence the price of shares = [ 3+(0.16/0.20)(6-3)]/0.20

= 5.4/0.20

= 27

b) Yes. According to Walters formula, their is a relationship between dividend policies and common stocks prices. According to him the dividend policy of a firm is based on the relationship between the internal rate of return (r) earned by it and the cost of capital or required rate of return (Ke)