Pls solve this

CMA KNVV Sri Vidya - Sri Kanth (C.A.Final (New) ICWAI FINAL (New))   (11269 Points)

23 August 2010  

 

ABC Ltd. has 50,000 outstanding shares.  The current market price per share is Rs.100 each.  It hopes to make a net income of Rs.5,00,000 at the end of current year.  The Company’s Board is considering a dividend of Rs.5 per share at the end of current financial year.  The company needs to raise Rs.10,00,000 for an approved investment expenditure.  The company belongs to a risk class for which the capitalization rate is 10%.  Show, how does the M-M approach affect the value of firm if the dividends are paid or not paid.

(6 Marks) (November, 2006)

Answer

When dividends are paid

 

100 = (5 + P1)/(1 + 0.10)

Therefore, P1 = Rs.105/-.

Value of firm

= Rs.([50,000/-+7,50,000/-/105/-) x 105/-] – 10,00,000/- + 5,00,000/-)/1.10

= Rs.(60,00,000/- - 5,00,000/-)/1.10

= Rs.50,00,000/-.

When dividend is not paid

100 = 1/1.1 x P1

Therefore, P1 = Rs.110/-.

Value of firm

= Rs.([50,000/- +(5,00,000/-/110/-) x 110/-] – 10,00,000/-+5,00,000/-)/1.10

= Rs.(60,00,000/- - 5,00,000/-) / 1.10

= Rs.50,00,000/-

M.M. approach indicates that the value of the firm in both the situations will be the same.