ABC Autos Ltd. started its business one year back with paid-up equity capital of ₹40 Lakh. Other details are as under: Earnings of the Year: ₹4,00,000 Dividend Paid: ₹3,20,000 Price-earnings ratio: 12.5 Number of shares:

Optimality of Dividend Payout Ratio using Walter's Model Given Information: Paid-up equity capital = ₹40,00,000 Earnings of the Year = ₹4,00,000 Dividend Paid = ₹3,20,000 Price-earnings ratio (P/E) = 12.5 Number of shares = 40,000 Calculations: 1. Earnings Per Share (EPS): EPS = Total Earnings / Number of Shares EPS = ₹4,00,000 / 40,000 = ₹10 2. Dividend Per Share (DPS): DPS = Total Dividend Paid / Number of Shares DPS = ₹3,20,000 / 40,000 = ₹8 3. Cost of Equity (K e ) or Capitalization Rate: K e = 1 / P/E Ratio K e = 1 / 12.5 = 0.08 or 8% 4. Rate of Return on Investment (r): r = EPS / Book Value Per Share (assuming earnings are generated from equity capital) Book Value Per Share = Paid-up Equity Capital / Number of Shares = ₹40,00,000 / 40,000 = ₹100 r = ₹10 / ₹100 = 0.10 or 10% Walter's Model Formula for Market Price Per Share (P): P = [DPS + (r/K e )(EPS - DPS)] / K e Applying Walter's Model with current DPS = ₹8: P = [8 + (0.10 / 0.08)(10 - 8)] / 0.08 P = [8 + (1.25)(2)] / 0.08 P = [8 + 2.5] / 0.08 P = 10.5 / 0.08 P = ₹131.25 To determine optimality, let's consider the optimal payout ratio based on Walter's Model: Walter's model suggests that if r > K e (as in this case, 10% > 8%), the firm should retain all earnings (i.e., DPS = 0) to maximize shareholder wealth. This is because the firm can earn a higher return on reinvested earnings than shareholders can earn on their own. Applying Walter's Model with optimal DPS = 0: P = [0 + (0.10 / 0.08)(10 - 0)] / 0.08 P = [0 + (1.25)(10)] / 0.08 P = 12.5 / 0.08 P = ₹156.25 Conclusion: Since r (10%) is greater than K e (8%), ABC Autos Ltd. is a growth firm. According to Walter's Model, such firms should have a zero dividend payout ratio (retain all earnings) to maximize the market price per share. The current market price per share (implied by P/E ratio) is 12.5 * 10 = ₹125. If the company pays a dividend of ₹8, the share price would be ₹131.25. However, if the company pays zero dividend, the share price would be ₹156.25. Therefore, the company's current dividend payout ratio (80% as DPS is ₹8 out of EPS ₹10) is not optimal . The optimal strategy would be to retain all earnings (nil dividend) to maximize shareholder wealth, leading to a higher share price of ₹156.25.