Similar to the traditional approach, the dividend policy given by James E Walter also considers that dividends are relevant and they do affect the share price. In this model he studied the relationship between the internal rate of return ( r ) and the cost of capital of the firm (k), to give a dividend policy that maximizes the shareholders’ wealth. The model studies the relevance of the dividend policy in three situations
r > ke
r < ke
r = ke
According to the Walter model, when the return on investment is more than the cost of equity capital, the firm can retain the earnings, since it has better and more profitable investment opportunities than the investors. It implies that the returns the investor gets when the company re-invests the earnings will be greater than what they earn by investing the dividend income.
Firms which have their r > ke are the growth firms and the dividend policy that suits is the one which has a zero pay-out ratio. This policy will enhance the value of the firm.
In the second case, the return on investment is less than the cost of equity capital and in such situation the investor will have a better investment opportunity than the firm. This suggests a dividend policy of 100% payout. This policy of a full pay-out ratio will maximize the value of the firm. Finally, when the firm has a rate of return that is equal to the cost of equity capital, the firms’ dividend policy will not affect the value of the firm. The optimum dividend policy for such firm will range between zero to a 100% pay-out ratio, since the value of the firm will remain constant in all the cases.
Assumptions
The relevance of the dividend policy as explained by the Walter’s Model is based on a few assumptions, which are
- Internal Financing: All the investments are financed by the firm through retained earnings. No new equity or debt is issued for the same.
- 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/Payout: 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.
Limitations
Most of the limitations for this model arise due to the assumptions made. They are: –
- The first assumption of exclusive financing by retained earnings make the model suitable only for all equity firms.
- Secondly, Walter assumes the return on investments to be constant. This again will not be true for firms making high investments
- Finally, Walter model on dividend policy ignores the business risk of the firm, which has a direct impact on the value of the firm. Thus, k cannot be assumed to be constant.