Walter's Model

Walter's Model, proposed by Professor James E. Walter, argues that dividend policy always affects the value of a firm. It emphasizes the relationship between a company's internal rate of return (r) and its cost of capital (k) in determining the optimal dividend policy to maximize shareholder wealth.

Core Concepts

• r (Internal Rate of Return): The rate of return a firm earns on its investments.
• k (Cost of Equity Capital): The minimum return required by equity investors.
• Dividend Payout Ratio: The percentage of earnings paid out as dividends.
• Retention Ratio: The percentage of earnings retained for reinvestment (1 - dividend payout ratio).
• Walter's model mixes dividend policy with investment policy of the firm.

Assumptions of Walter's Model

Walter's model is based on several key assumptions:

1. Internal Financing Only: All investments are financed through retained earnings. No new equity or debt is issued.
2. Constant r and k: The internal rate of return (r) and the cost of capital (k) remain constant. The business risk remains the same for all investment decisions.
3. 100% Payout or Retention: All earnings are either reinvested internally or distributed as dividends. There are no other uses for earnings.
4. Constant EPS and DIV: Beginning earnings per share (EPS) and dividends per share (DIV) are constant and never change.
5. Infinite Time: The firm has a very long or infinite lifespan.

Walter's Formula for Share Valuation

Walter proposed the following formula to determine the value of a share:

P = D/k + (r(E-D)/k) / k

Where:

• P = Market price per share
• D = Dividend per share
• r = Internal rate of return
• E = Earnings per share
• k = Cost of equity capital

This equation implies that the market price per share is the sum of:

1. The present value of an infinite stream of constant dividends (D/k).
2. The present value of an infinite stream of capital gains (r(E-D)/k) / k.

Relationship Between Dividend Decision and Firm Value

Walter's model suggests that the optimal dividend payout depends on the relationship between 'r' and 'k':

Implications of Walter's Model

Walter's model has important implications for firms at various stages of growth:

• Growth Firms (r > k): These firms have abundant profitable investment opportunities. The optimal payout ratio is 0%. Reinvesting all earnings generates higher returns for shareholders than they could achieve on their own.
• Normal Firms (r = k): The firm can make returns equal to that of a shareholder. The firms in normal phase will make returns equal to that of a shareholder. The dividend policy is of no relevance in such a scenario and There is no optimum payout ratio.
• Declining Firms (r < k): Declining firms earn returns lower than what shareholders can achieve elsewhere. The optimum payout ratio is 100%. Distributing all earnings maximizes shareholder wealth.

Criticisms of Walter's Model

Walter's model is subject to several criticisms:

• Internal Financing Only: The assumption that investments are financed solely through retained earnings is unrealistic. Firms often use external financing (debt or equity).
• Constant r and k: The assumption of constant internal rate of return (r) and cost of capital (k) is also unrealistic. As investment and risk patterns change, these values tend to fluctuate.

No external financing: Walter's model of share valuation mixes dividend policy with investment policy of the firm. The model assumes that retained earnings finance the investment opportunities of the firm and no external financing—debt or equity—is used for the purpose. When such a situation exists, either the firm's investment or its dividend policy or both will be sub-optimum.

In conclusion, while Walter's Model provides valuable insights into the relationship between dividend policy and firm valuation, its reliance on simplifying assumptions limits its applicability in the real world. However, it offers a useful framework for understanding how a company's investment opportunities and the required return of investors influence dividend decisions.