CA Inter P6 · Chapter 8
Dividend Decision MCQs with Answers
8 multiple-choice questions on Dividend Decision for CA Inter P6 Financial Management and Strategic Management. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
Using Gordon's model, a firm has EPS of ₹ 15, retains 40% of earnings, earns 12% on investments and has a cost of equity of 14%. The price per share (to two decimals) is:
- A) ₹ 107.14
- B) ₹ 88.24
- C) ₹ 97.83
- D) ₹ 64.29
Show answer & explanation
Answer: C) ₹ 97.83
g = b x r = 0.40 x 12% = 4.8%. Dividend = E(1 - b) = 15 x 0.60 = ₹ 9. P = E(1 - b) / (Ke - br) = 9 / (0.14 - 0.048) = 9 / 0.092 = ₹ 97.83. Swapping the payout and retention ratios gives ₹ 88.24.
Question 2
Kamal Ltd has EPS of ₹ 12 and pays a dividend of ₹ 4 per share. Its internal rate of return is 18% and the equity capitalisation rate is 15%. Using Walter's model, the market price per share is:
- A) ₹ 26.67
- B) ₹ 90.67
- C) ₹ 122.67
- D) ₹ 80.00
Show answer & explanation
Answer: B) ₹ 90.67
Walter's model: P = [D + (r/Ke)(E - D)] / Ke = [4 + (0.18/0.15)(12 - 4)] / 0.15 = (4 + 1.2 x 8) / 0.15 = 13.6 / 0.15 = ₹ 90.67. E/Ke = ₹ 80 would be the price at 100% payout, which is lower because r is greater than Ke.
Question 3
According to Walter's model, if a firm's internal rate of return (r) is greater than its cost of equity (Ke), the optimum dividend payout ratio is:
- A) Zero, that is, retain all earnings
- B) 100%
- C) 50%
- D) Irrelevant, as any payout gives the same price
Show answer & explanation
Answer: A) Zero, that is, retain all earnings
Under Walter's model, if r > Ke the firm is a growth firm and creates more value by reinvesting earnings than shareholders could earn themselves. The share price is maximised at a zero payout. If r < Ke the optimum payout is 100%, and if r = Ke the payout is irrelevant.
Question 4
The current market price of an equity share is ₹ 100 and the equity capitalisation rate is 12%. The company expects to declare a dividend of ₹ 6 per share at the end of the year. Under the Modigliani-Miller approach, the price per share at the end of the year if the dividend is paid will be:
- A) ₹ 112
- B) ₹ 94
- C) ₹ 118
- D) ₹ 106
Show answer & explanation
Answer: D) ₹ 106
Under MM, P0 = (D1 + P1) / (1 + Ke), so P1 = P0(1 + Ke) - D1 = 100 x 1.12 - 6 = ₹ 106. If no dividend were paid, P1 would be ₹ 112. The shareholder's total wealth is the same either way (₹ 106 + ₹ 6 = ₹ 112), which shows MM's dividend irrelevance.
Question 5
Under the Modigliani-Miller approach, a company with 2,00,000 equity shares expects net income of ₹ 20,00,000 for the year and plans new investment of ₹ 30,00,000. It pays a dividend of ₹ 6 per share, and the expected market price per share at the end of the year after the dividend is ₹ 106. How many new shares must it issue to finance the investment (rounded up to the next whole share)?
- A) 19,643 shares
- B) 20,755 shares
- C) 9,434 shares
- D) 28,302 shares
Show answer & explanation
Answer: B) 20,755 shares
Dividend paid = 2,00,000 x 6 = ₹ 12,00,000, so retained earnings = 20,00,000 - 12,00,000 = ₹ 8,00,000. New funds needed = 30,00,000 - 8,00,000 = ₹ 22,00,000. Number of new shares = 22,00,000 / 106 = 20754.72, rounded up to 20,755 shares. Using the no-dividend price of ₹ 112 would be inconsistent with the dividend being paid.
Question 6
A company's dividend for the last year was ₹ 3 per share. EPS for the current year is ₹ 10, the target payout ratio is 50% and the speed of adjustment is 0.6. Using Lintner's model, the expected dividend for the current year is:
- A) ₹ 4.20
- B) ₹ 3.00
- C) ₹ 5.00
- D) ₹ 3.80
Show answer & explanation
Answer: A) ₹ 4.20
Lintner's model: D1 = D0 + [(EPS x target payout) - D0] x adjustment factor = 3 + [(10 x 0.5) - 3] x 0.6 = 3 + 2 x 0.6 = ₹ 4.20. The model shows that firms adjust dividends gradually towards the target rather than jumping to ₹ 5 at once.
Question 7
When a company issues fully paid bonus shares to its equity shareholders out of free reserves, the effect is that:
- A) Total shareholders' funds increase by the amount of the bonus issue
- B) Each shareholder's proportionate ownership in the company increases
- C) Paid-up share capital increases and reserves decrease, with no change in total shareholders' funds
- D) Cash and bank balances fall by the amount capitalised
Show answer & explanation
Answer: C) Paid-up share capital increases and reserves decrease, with no change in total shareholders' funds
A bonus issue capitalises reserves. Free reserves are transferred to share capital, so the components of shareholders' funds change but the total does not. No cash leaves the company. Each shareholder receives shares in proportion to existing holdings, so proportionate ownership is unchanged.
Question 8
The 'bird-in-the-hand' argument, associated with Gordon's model, states that:
- A) Share buy-backs are always preferable to cash dividends
- B) Dividend policy has no effect on the value of the firm in perfect capital markets
- C) Investors value a rupee of dividend today more than an uncertain capital gain in future, so they discount distant returns at a higher rate
- D) Firms should always retain all earnings when r equals Ke
Show answer & explanation
Answer: C) Investors value a rupee of dividend today more than an uncertain capital gain in future, so they discount distant returns at a higher rate
Gordon argued that investors are risk-averse and see near dividends as more certain than future capital gains. So a higher retention (and more distant return) raises the discount rate investors apply, and dividend policy matters even when r = Ke. Dividend irrelevance in perfect markets is the MM view.