Page 202 - DMGT409Basic Financial Management

Unit 13: Theory and Forms of Dividend

Walters models is based on the following assumptions Notes

1. The fi rm finances its entire investments by means of retained earning only.

2. Internal rate or return (R) and cost of capital (K) of the firm remains constant.

3. The firms earning are either distributed as dividend or reinvested internally.
4. Beginning earnings and dividends of the firm will never change.

5. The firm has a very long or infi nite life.
D + r / k (E − D )
P =
K
P = Market price per share.
D = Dividend per share
E = Earning per share

R = Interest rate per capital
K = Cost of capital.
According to the theory, the optimum dividend policy depends on the relationship between
the firm’s internal rate of return and cost of capital. If R>K , the firms should retain the entire

earnings.

Notes Walter’s view on optimum dividend payout ratio can be summarized as below:

1. Growth Firms: (R>K): The firms having R>K may be referred to as growth opportunities.
These firms naturally can earn a return which is more than what shareholders could

earn on their own. So optimum payout ratio for growth firm is 0%.

2. Normal Firms (R = K): If R is equal to K the firm is known as normal firm. These fi rms

earn a rate of return which is equal to that of shareholders in this case dividend policy

will not have any influence on the price per share. So there is nothing like optimum
payout ratio for a normal firm. All the payout ratios are optimum.

3. Declining Firms (R<K): If the company earns a return which is less than, what the
shareholders can earn on their investments, it is known as declining firm. Here it

should not make any sense to retain the earnings. So entire earnings optimum payout

ratio for a declining firms is 100%.
So according to walter the optimum payout ratio is either 0% (when R>K) or 100% (when
R<K).

Criticisms

Walter’s model based on certain assumptions, which are true for Walter but not true in the real
world. The following are the limitations of the Walter’s model.

1. Walter assumes that there is no external financing. When R>K , the firm must issue additional

security and finance its profitable investments, if the company uses only retained earnings,

all the profitable investments cannot be undertaken. So the investment decision of the fi rm

will be sub-optimum.

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