Page 303 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 14: Management of Surplus & Dividend Policy

2. R /R is equal to I, when the actual and normal capitalization rates are identical. In this Notes
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.
2. The assumption that the return on investment remains constant will not be true for firms
making high investments.
3. It ignores the business risk of the firm, which has a direct impact on the value of the firm.

Example: To illustrate approaches to dividend decisions using Walter Model
Let us consider a firm with 4 earnings per share and 3 current dividend. The firm is currently
selling for 22 per share and thus has an actual capitalization rate of 4/22 or 18%. The normal
capitalization rate for the industry is 12 per cent. The firm has a need for cash and is considering
lowering the dividend to 2 per share. What effect would this have on the value of common
share by using Walter Model?

3  18/12 1 4.5

3 dividend =  37.5
.12 .12

2  18/12 2 5
2 dividend =  41.67
.12 .12
14.3.3 Gordon’s Dividend Capitalization Model

Another model that has given importance to dividend policy of the firm is the Gordon Model.
Gordon Model assumes that future dividends are the sole determinant of the intrinsic value of
the common shares.

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