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Walter’s Model is based on the model of dividend. Organisations give dividends, which is a percentage of earnings, to their shareholders as a reward for their investment in the venture. The dividend model also determines the proportion of money that will be reinvested in the organisation to facilitate growth and platform expansion. The primary aim of financial management is to facilitate growth and development in the organisation. Walter’s Model demonstrates that the dividend of any organisation is co-related to the organisation’s market value. Walter’s Model is demonstrated based on a number of assumptions.
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Walter’s Model
Walter’s Model, as the name suggests, was introduced by Prof. James E. Walter. The model is based on share valuation and postulates that both prices of share and dividends are interdependent. On the other hand, this model is based on the statement that investment and dividend are interrelated. Many organisations use the model for maintaining the share prices in the market.
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Walter’s Model Description
Walter’s Model demonstrates the relationship between the internal rate of return (r) or returns on investment with the capital cost (k). So, the decision made on the dividend affects the operation of all other financial domains of the organisation. In simple words,
Walter’s Model provides insight into how dividends affect the organisation’s overall return:
Suppose the rate of return is greater than the cost of capital (r > k). In that case, the organisation must hold their earnings to increase investment opportunities. The organisation will earn more compared to the reinvestment made by shareholders. Organisations that earn or gain more returns than costs incurred are known as growth firms. The payout of such firms is zero.
If the rate of return is equal to the cost of capital (r = k), then the organisation’s dividend will not impact its value. In such conditions, the organisation has to decide how much they will keep and how much they will distribute among shareholders. The payout ratio changes with different circumstances in the case. It would either be zero or 100%.
Suppose the rate of return is less than the cost of return (r < k), then the organisation should have distributed all its return or earnings among the shareholders through dividends. It will give rise to more investment opportunities for the future. The payout ratio, in this case, remains 100%.
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Relation of the Rate of Return with the Cost of Return
As per Walter’s Model, the rate of return (r), and cost of return have the following impact on the firm’s values:
Relation | If payout of dividend increases | If payout of dividend decreases |
r > k | Firm’s value decreases | Firm’s value increases |
r = k | No effect | No effect |
r < k | Firm’s value increases | Firm’s value decreases |
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Walter’s Model Formula
According to Walter’s Model Formula, the market value of a share can be given as:
P = D + (E-D) ( r/k ) / k |
Here,
P = The value of the share price on every equity (price per equity share)
D = The dividend value on every share (dividend per share)
E = The value of earning on every share (earnings per share)
(E-D) = The value that comes after subtracting the dividend of share from earning (retained earnings per share).
r = The value of return on every investment (rate of return on investments)
K = It is the cost of equity.
Assumptions in Walter’s Dividend Model
All the financial domains like return or cost used will be savings. No external earning or investment will be used.
The value of rate (r) of return and the value of the cost of capital (k) will never change. It will remain constant, even if investment value changes.
The entire return will be distributed among the shareholders through dividends. The organisation does not keep a single percentage of the return value.
Every share’s earnings will remain equal to the dividend on every share.
The organisation’s standard must be standard and perpetual, so the organisation fulfils the needs of the model.
Limitations of Walter’s Model
It is assumed that no external earning or investment is used in this model. In this case, the value of investment policy and dividend policy comes below standard.
The scope of Walter’s Model is limited to equity-based organisations. In this model, it is assumed that the rate of return never changes, but its value decreases as investment increases.
In Walter’s Model, the value of the cost of capital never changes, which is an unrealistic approach. This assumption ignores the risk on the organisation and the impacts of risk on the organisation’s value.
Conclusion
Walter’s Model is based on various assumptions. The model has its limitations too. Nevertheless, the model helps to demonstrate the relationship between the dividends policy and the prices of shares. Based on this model, the dividend policy of any organisation can be depicted as the interlink between the cost of capital and the internal rate of return . This model also demonstrates that organisations should first make profitable investments and then make other less profitable investments. The model plays a significant role in maintaining organisations’ financial policies and in determining their price in the share market.
