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Mr. Mustaq Mulla, SRFGCC, Kitturu Rani Channamma University Belagavi , profile picture
Uploaded byMr. Mustaq Mulla, SRFGCC, Kitturu Rani Channamma University Belagavi
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Dividend Decision Policy - "Walter Model"

Walter Model with assumptions, formula, implications, and limitations

Economy & Finance◦
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INTRODUCTION TO FINANCIAL MANAGEMENT:- Mr. MUSTAQ MULLA UGC-NET,K-SET, (Ph.D.) Teaching Assistant, Department of studies and Research in Commerce, Sangolli Rayanna First Grade Constituent College, Rani Channamma University, Belagavi Dividend Decision Policy
Walter's Model James E. Walter developed one of the earliest and most straightforward models demonstrating the relevance of dividend policy. Walter's model suggests that the optimal dividend policy depends on the relationship between the firm's internal rate of return (r) and its cost of capital (k).
Assumptions of Walter's Model Walter's model rests on several key assumptions: 1. Internal Financing Only: The firm finances all investments through retained earnings; external financing (debt or equity) is not used. 2. Constant r and k: The firm's internal rate of return (r) and cost of capital (k) are constant. 3. 100% Payout or Retention: All earnings are either distributed as dividends or reinvested in the firm. 4. Infinite Time Horizon: The firm has an infinite life. 5. No Taxes: There are no taxes on dividends or capital gains.
Implications of Walter's Model Walter's model provides insights into the optimal dividend policy based on the relationship between 'r' and 'k':  r > k (Growth Firm): If the firm's internal rate of return is greater than its cost of capital, the firm should retain all earnings and reinvest them. This will lead to a higher stock price. In this case, the optimal dividend payout ratio is zero.  r < k (Declining Firm): If the firm's internal rate of return is less than its cost of capital, the firm should distribute all earnings as dividends. This will maximize the stock price. In this case, the optimal dividend payout ratio is 100%.  r = k (Normal Firm): If the firm's internal rate of return is equal to its cost of capital, the dividend policy is irrelevant. The market price of the share will be the same regardless of the dividend payout ratio.
👉 According to Walter, Companies paying higher dividends have more value compared to companies that pay lower dividends or do not pay dividends at all. He identified two major factors that influence the market price of a share: 1. Dividend payout ratio of the company, and 2. The relationship between the internal rate of return (r) of the company and the cost of capital (k).
r and k Increase in Dividend Payout Decrease in Dividend Payout r > k Value of the firm decreases Value of the firm increases r < k Value of the firm increases Value of the firm decreases r = k No change in firm value No change in firm value Relationship Between r and k and Its Effect on Firm Value
Limitations of Walter's Model Despite its simplicity and intuitive appeal, Walter's model has several limitations: Unrealistic Assumptions: The assumptions of no external financing, constant 'r' and 'k', and no taxes are highly unrealistic in the real world. Ignores Investor Preferences: The model does not consider investor preferences for dividends or capital gains. Static Model: It is a static model and does not account for changes in the firm's investment opportunities or cost of capital over time.
Question No 1. From the following information, ascertain whether the firm is following an optimum dividend policy as per Walter’s Model (market price high): • Total earnings: ₹3,00,000 • Number of equity shares of ₹100 each: 20,000 shares • Dividend paid: ₹1,00,000 • Cost of capital (Ke): 10% • Return on investment (r): 15% The firm is expected to maintain its return on fresh investments. a) Find out the market price per share using Walter’s Model. b) Also calculate the dividend payout ratio at which the market value of the share becomes maximum.
Question 3. X Company earns ₹10 per share. Its capitalization rate (Ke) is 10% and its return on investments is 18%. According to Walter’s Model: a) What should be the price per share at 25% dividend payout ratio? b) Is this the optimum payout ratio as per Walter? Question 2. The EPS of the company is ₹80, and the rate of capitalisation applicable to the company is 12%. The company can adopt any of the following dividend payout ratios: 25%, 50%, 75%, or 100%. Using Walter’s Model, compute the market price of the equity share of the company when the rate of return (r) is: 1. 8% 2. 12% 3. 15%
Limitations of Walter's Model Despite its simplicity and intuitive appeal, Walter's model has several limitations:  Unrealistic Assumptions: The assumptions of no external financing, constant 'r' and 'k', and no taxes are highly unrealistic in the real world.  Ignores Investor Preferences: The model does not consider investor preferences for dividends or capital gains.  Static Model: It is a static model and does not account for changes in the firm's investment opportunities or cost of capital over time.