10. Walter's Dividend Model

Walter's Dividend Model

Walter's model supports the principle that dividends are relevant. The investment policy of a firm cannot be separated from its dividend policy and both are inter-related. The choice of an appropriate dividend policy affects the value of an enterprise.

Assumptions of this model:

• Retained earnings are the only source of finance. This means that the company does not rely upon external funds like debt or new equity capital.
• The firm's business risk does not change with additional investments undertaken. It implies that r(internal rate of return) and k(cost of capital) are constant.
• There is no change in the key variables, namely, beginning earnings per share(E), and dividends per share(D). The values of D and E may be changed in the model to determine results, but any given value of E and D are assumed to remain constant in determining a given value.
• The firm has an indefinite life.

Formula: Walter's model

P

=

D    Ke – g

Where:	P	=	Price of equity shares
	D	=	Initial dividend
	Ke	=	Cost of equity capital
	g	=	Growth rate expected

After accounting for retained earnings, the model would be:

P

=

D    Ke – rb

Where:	r	=	Expected rate of return on firm’s investments
	b	=	Retention rate (E - D)/E

Equation showing the value of a share (as present value of all dividends plus the present value of all capital gains) – Walter's model:

P

=

D + r/ke (E - D) ke

Where:	D	=	Dividend per share and
	E	=	Earnings per share

Example:

A company has the following facts:
Cost of capital (ke) = 0.10
Earnings per share (E) = $10
Rate of return on investments ( r) = 8%
Dividend payout ratio: Case A: 50% Case B: 25%
Show the effect of the dividend policy on the market price of the shares.

Solution:

Case A:

D/P ratio = 50%
When EPS = $10 and D/P ratio is 50%, D = 10 x 50% = $5

P

=

5 + [0.08 / 0.10] [10 - 5] 0.10

=> $90

Case B:

D/P ratio = 25%
When EPS = $10 and D/P ratio is 25%, D = 10 x 25% = $2.5

P

=

2.5 + [0.08 / 0.10] [10 - 2.5] 0.10

=> $85

Conclusions of Walter's model:

• When r > ke, the value of shares is inversely related to the D/P ratio. As the D/P ratio increases, the market value of shares decline. It’s value is the highest when D/P ratio is 0. So, if the firm retains its earnings entirely, it will maximize the market value of the shares. The optimum payout ratio is zero.
• When r < ke, the D/P ratio and the value of shares are positively correlated. As the D/P ratio increases, the market price of the shares also increases. The optimum payout ratio is 100%.
• When r = ke, the market value of shares is constant irrespective of the D/P ratio. In this case, there is no optimum D/P ratio.

Limitations of this model:

• Walter's model assumes that the firm's investments are purely financed by retained earnings. So this model would be applicable only to all-equity firms.
• The assumption of r as constant is not realistic.
• The assumption of a constant ke ignores the effect of risk on the value of the firm.