# 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

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

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.

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