Page 220 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 9: Dividend Decisions

E = Earnings per share Notes
D = Dividend per share
Analyzing the Walter Formula:
EPS (Earnings per share)
We know that the value of share =
Capitalization rate
Divident + Retained Earnings
=
R
a
The Walter formula gives an added weight to the retained earning portion of the earnings
formula. The factor is placed in front of retained earnings to change its weighted value under
three different situations as follows:
1. If R /R is greater than I i.e., the firms earnings are more than the norm. In this situation
a c
we want the firm to retain its earnings since other alternative investment offer a lower
return than the firm is about to secure.

Example: A firm has EPS 5 and pay dividend of 2. Its actual capitalization rate is 15%
and normal capitalization rate is 10%. What is the value of the firm using capitalization earnings
and Walter formula?
Capitalization earnings = Value = 5/10% = 50
15 6.5
Walter formula value = 2 + 2+ 2 + (5 – 2 ) = = 65
10 10%
2. R /R is equal to I, when the actual and normal capitalization rates are identical. In this
a c
case, the retained earnings have the same weighted value as dividends and the Walter
Formula gives the same value as the Capitalization Earnings formula.
3. R /R is less than I i.e., retained earnings have a lower weight than dividends. Thus less the
a c
firm retain, the higher its value. In the above example, if the capitalization (actual) is 5%.
Value of the firm Capitalization of earnings 5/10% = 50
(5 – 2) 3.5
Value of the Firm Walter formula = 2 + 5/10 = = 35
10% 10%
Assumption of the Walter Model

1. Retained earnings are the only source of finance available to the firm, with no outside
debt or additional equity used.
2. R and R are assumed to be constant and thus additional investments made by the firm
a c
will not change its risk and return.
Profiles

1. Firm has an indefinite life.
2. For a given value of the firm, the dividend per share and the earnings per share remain
constant.

Limitations of the Walter Model

1. Exclusive financing by retained earnings make the model suitable only for all equity
firms.

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