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Financial Management - DIVIDEND POLICIES

Walter’s Model - DIVIDEND POLICIES

   Posted On :  20.06.2018 05:55 am

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:

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:

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

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

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

Infinite time: the firm has infinite life

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

= DIV/k + [(EPS-DIV) r/k]/k, where 

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:

1. The first component (DIV/k) is the present value of an infinite stream of dividends and

2. The second component [(EPS – DIV) / k) / k] is the present value of the infinite stream of capital appreciation. This is the capital gain when the firm retains the earnings within the firm.

Could we note something peculiar here?

i. When the rate of return is greater than the cost of capital (r > k), the price per share increases as the dividend payout ratio decreases.

Such firms are recognized as growth firms. For them the internal rate is more than the cost of capital (r > k). They expand rapidly because of available investment opportunities resulting in returns higher than the cost of capital employed.

These firms will be able to reinvest earnings at a higher rate ( r ) than the shareholders’ expected rate of return ( k ). They will maximize the market value per share as they follow a policy of retaining earnings for reinvestment or internal investment. This is also revealed by the Firm Y in our earlier table of calculations.

ii. When the rate of return is equal to the cost of capital (r=k), the price per share does not vary with changes in dividend payout ratio.

Such firms are treated as normal firms in the market place. They do not have unlimited surplus generating investment opportunities, yielding higher returns than the cost of the capital. Once they exhaust all portfolios of super profitable opportunities, they earn just a return equal to the cost of capital on their investments. Here the dividend policy has no impact on the market value per share.

iii. When the rate of return is lesser than the cost of capital (r< k), the price per share increases as the dividend payout ratio increases.

Such firms are viewed as declining firms in the market place. They do not have any profitable portfolio of investment opportunities to invest their earnings. These firms would only earn on their investments a rate of return less than the minimum rate required by the investors and that can be obtained elsewhere in the normal circumstances.
 
Investors in such declining firms would require earnings distributed to them so that they can either spend it or invest elsewhere to get a higher rate of return. The market value of such declining firms will be high only when it does not retain any earnings at all.

Thus in a nut shell,

1. The optimum payout ratio for a growth firm (r > k) is nil.

2. The optimum payout ratio for a normal firm (r = k) is irrelevant

3. The optimum payout ratio for a declining firm (r< k) is 100%

The dividend policy of a firm depends on the availability of investment opportunities and the relationship between the firm’s internal rate of return and its cost of capital.

Despite its popularity does the Walter’s model suffer from any limitation?

As we have seen that this model can be useful to show the effects of dividend policy on all equity firms under different assumptions about the rate of return. However the simplified nature of the model can lead to conclusions, which are not true in general, though true for the model. Now we will analyse the model critically on the following points:

1. No External Financing


Walter’s model of share valuation mixes dividend policy with investment policy of the firm. The model assumes that retained earnings finance the investment opportunities of the firm only and no external financing-debt or equity-is used for the purpose. When such a situation exists, either the firm’s investment or its dividend policy or both will be suboptimum.

2. Constant rate of return


Walter’s model is based on the assumption that r is constant. In fact, r decreases as more and more investment is made. This reflects the assumption that the most profitable investments are made and then the poorer investments are made. The firm should stop at a point where r = k.


3. Constant opportunity Cost of Capital, k

 

A firm’s cost of capital or discount rate, k, does not remain constant; it changes directly with the risk. Thus the present value of the firm’s income moves inversely with the cost of capital. By assuming that the discount rate, k, is constant, Walter’s model abstracts from the effect of risk on the value of the firm.
 
Let us now try some problems to make the concept clearer.
 
Example
 
The following information is available for ABC Ltd. Earnings per share: Rs. 4 Rate of return on investments: 18 percent Rate of return required by shareholders: 15 percent What will be the price per share as per the Walter model if the payout ratio is 40 percent? 50 percent? 60 percent?



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