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Walter’s model on dividend policy

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Walter’s model on dividend policy is explained in a logical manner

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Walter’s model on dividend policy

  1. 1. Walter’s Model on Dividend Policy Contents : 1. Explanation of the model 2. Assumptions of the model 3. Model’s valuation formula 4. Criticism of the model 5. Implications of the model 6. Note on IRR 7. Note on PER 8. Note on Cost of Equity
  2. 2. Prof. James E Walter formed a model for share valuation that states that the dividend policy of a company has an effect on its valuation. The companies paying higher dividends have more value as compared to the companies that pay lower dividends or do not pay at all. He categorized 2 factors that influence the price of the share viz. 1. Dividend payout ratio of the company, AND 2. the relationship between the internal rate of return of the company( r ) and the cost of capital (k)
  3. 3. Assumptions of Walter’s Model Walter’s model is based on the following assumptions: Internal Financing All the investments are financed by the firm through retained earnings. In other words, 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. Constant IRR and Cost of Capital The internal rate of return (r) and the cost of capital (k) of the firm are constant. The business risks remain same for all the investment decisions. Constant EPS and DPS Beginning earnings and dividends of the firm never change. Though different values of EPS and DPS may be used in the model, but they are assumed to remain constant while determining a value. 100% Retention or Pay-out All the earnings of the company are either reinvested internally or distributed as dividends. Infinite Life The company has an infinite or a very long life.
  4. 4. Walter’s Model’s Valuation Formula Walter’s formula to calculate the market price per share (P) is: Where, P = market price per share D = dividend per share E = earnings per share r = internal rate of return of the firm k = cost of capital of the firm
  5. 5. Explanation: The mathematical equation indicates that the market price of the company’s share is the total of the present values of:  An infinite flow of dividends, and  An infinite flow of gains on investments from retained earnings The formula can be used to calculate the price of the share if the values of other variables are available.
  6. 6. Example A company has an EPS of $15. The market rate of discount applicable to the company is 12.5%. Retained earnings can be reinvested at IRR of 10%. The company is paying out $5 as a dividend. Calculate the market price of the share using Walter’s model. Answer Market Price per Share (P) is calculated as :
  7. 7. Criticism of Walter’s Model Walter’s theory is critiqued for the following unrealistic assumptions in the model:  No External Financing Walter’s assumption of complete internal financing by the firm through retained earnings is difficult to follow in the real world. The firms do require external financing for new investments.  Constant r and k It is very rare to find the internal rate of return and the cost of capital to be constant. The business risks will definitely change with more investments which are not reflected in this assumption.
  8. 8. Implication of Walter’s Model Walter’s model has important implications for firms in various levels of growth as described below:  Growth Firm Growth firms are characterized by an internal rate of return > cost of the capital i.e. r > k. These firms will have surplus profits to invest. Because of this, the firms in growth phase can earn more return for their shareholders in comparison to what the shareholders can earn if they reinvested the dividends. Hence, for growth firms, the optimum payout ratio is 0%.  Normal Firm Normal firms have an internal rate of return = cost of the capital i.e. r = k. The firms in normal phase will make returns equal to that of a shareholder. Hence, the dividend policy is of no relevance in such a scenario. It will have no influence on the market price of the share. So, there is no optimum payout ratio for firms in the normal phase. Any payout is optimum.
  9. 9.  Declining Firm Declining firms have an internal rate of return < cost of the capital i.e. r < k. Declining firms make returns that are less than what shareholders can make on their investments. So, it is illogical to retain the company’s earnings. In fact, the best scenario to maximize the price of the share is to distribute entire earnings to their shareholders. The optimum dividend payout ratio, in such situations, is 100%.
  10. 10. Notes # 1: Internal Rate of Return (IRR) The internal rate of return is a discounting cash flow technique which gives a rate of return that is earned by a project. We can define the internal rate of return as the discounting rate which makes a total of initial cash outlay and discounted cash inflows equal to zero. In other words, it is that discounting rate at which the net present value is equal to zero. Example Suppose a company is investing in a simple project which will fetch $5000 in the next 3 years and the initial investment in the project is say $10,000. The internal rate of return is 23.38%. It makes the decision making very simple. We just need to compare these % returns to the one which we can get by investing somewhere.
  11. 11. Notes # 2: Price- Earning Ratio (PER) The ratio of a company's share price to its per-share earnings. Where, PER = Price-Earnings Ratio MPS = Market Price per Share EPS = Earnings per Share
  12. 12. Notes # 3 : Cost of Equity The cost of equity is the return a company requires to decide if an investment meets capital return requirements. it is often used as a capital budgeting threshold for required rate of return. A firm's cost of equity represents the compensation the market demands in exchange for owning the asset and bearing the risk of ownership. In the case of an all equity company when the growth rate of dividend is zero, the Cost of Capital ( k ) is the Cost of Equity which is the inverse of Price Earnings Ratio i.e.,

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