Page 302 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes Limitations

A firm’s share price may rise even in case of low pay out ratio if its earnings are increasing. Here
the capital gains for the investor will be higher than the cash dividends. Similarly, for a firm
having a high dividend payout ratio with a slow growth rate, there will be a negative impact on
the market price (because of lower earnings). In addition, some investors may prefer cash
dividends to the uncertain capital gains that may arise in future.
14.3.2 Walter’s Model

Walter’s Model supports the doctrine that dividends are relevant. The investment policy of a
firm cannot be separated from its dividend policy and both are, according to Walter, interlinked.
The choice of an appropriate dividend policy affects the value of an enterprise.
The relationship between dividend and share price on the basis of Walter’s formula is shown
below:

D+R /R (E  D)
a
c
V =
c R c
Where,
V = Market value of the ordinary shares of the company
c
R = Actual capitalization rate
a
R = Normal capitalization rate expected by the investors
c
E = Earnings per share

D = Dividend per share
Analyzing the Walter Formula:
We know that the value of share =

EPS(Earningpershare) Divident  Retained Earnings
Capitalization rate = R a
The Walter formula gives an added weight to the retained earning portion of the earnings
R a
formula. The factor R is placed in front of retained earnings to change its weighted value
c
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  (5 2)   65
10 10%

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