Dividend Relevance: Walter’s Model

Prof. James E. Walter argues that the choice of dividend policies almost always affect the value of the firm. His model is based on the following assumptions:

1. Internal financing: The firm finances all investment through retained earnings; i.e. debt or new equity is not issued.

2. Constant return and cost of capital: the firm’s rate of return, r , and its cost of capital, k , are constant.

3. 100% payout or retention: All earnings are either distributed as dividends or reinvested internally immediately.

4. Infinite time: the firm has infinite life

Valuation Formula: Based on the above assumptions, Walter put forward the following formula:

P = DIV + (EPS-DIV) r/k

k

P = market price per share

DIV= dividend per share

EPS = earnings per share

DIV-EPS= retained earnings per share

r = firm’s average rate of return

k= firm’s cost o capital or capitalisation rate

The above equation is reveals that the market price per share is the sum of two components:

The first component k

b. The second component (EPS-DIV) r/k is the present value of an infinite stream of

k returns from retained earnings.

Let’s apply the theoretical formula to a practical illustration to improve our understanding. We will take three models, one of a growth firm, the other normal firm and a declining firm. The financial data of all the three firms is given as follows:

Growth firm for details please visit- http://www.mbachannel.blogspot.in/2014/05/dividend-relevance-walters-model.html

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