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WALTERs MODEL

Relevance of dividends
Introduction


Walters model relates distribution of
dividends to available investment
opportunities
Theory
Dividends are relevant

Investment policy of a firm cannot be separated from
its dividend policy & both are interlinked.

Relationship between the return on a firms
investment (r) and Cost of capital (k)

If return on investment exceeds Cost of
capital firm should retain its earnings

If Cost of capital exceeds Return on
Investment firm should distribute
earnings to shareholders
When r>k: Growth firms

Firm should plough back entire earnings within the firm, as a
result market value of shares will be maximized.

D/P ratio=0 which is the optimum dividend policy .




When r<k:
Firm do not have profitable investment opportunities
Market price of shares will be maximized by distribution of entire
earnings as dividends
D/P ratio=100

When r=k: Normal firms

Matter of indifference whether earnings are retained or
distributed.

For such firms there is no optimum dividend policy i.e. D/P
ratio.

Formula
The formula is based on share valuation
model & is given by
P= D
k(e)-g
P= price of equity shares
D=Initial dividend
k(e)=cost of equity capital
g= expected growth rate of earnings
Assumptions
All financing is done through retained earnings.

With additional investments undertaken firms business
risk does not change.

There is no change in beginning earnings per share &
dividends per share

The firm has perpetual life


Limitations
Walters model assumes that firms investments are
financed exclusively by retained earnings, this model is
only applicable for all-equity firms.

Model assumes Return on firms investment (r) as constant
this cannot be realistic because when increased investments
are made by firm r changes.

Walters model ignores effect of risk on the value of the
firm, by assuming constant k(e) risk complexion of firm.