Financial Management

DIVIDEND POLICIES
Walter’s Model on Dividend Policy
Prof. James E Walter formed a model for share valuation that states that the dividend policy of a
company has an effect on its valuation.
The companies paying higher dividends have more value as compared to the companies that
pay lower dividends or do not pay at all.
He categorized 2 factors that influence the price of the share viz.
1. Dividend payout ratio of the company
2. the relationship between the internal rate of return of the company( r ) and the cost of capital
(k)
Assumptions of Walter’s Model
Internal Financing: All the investments are financed by the firm through retained earnings. In other words, retained
earnings are the only source of finance. This means that the company does not rely upon external funds like debt or
new equity capital.

Constant IRR and Cost of Capital : The internal rate of return (r) and the cost of capital (k) of the firm are constant. The
business risks remain same for all the investment decisions.

Constant EPS and DPS: Beginning earnings and dividends of the firm never change. Though different values of EPS and
DPS may be used in the model, but they are assumed to remain constant while determining a value.

100% Retention or Pay-out: All the earnings of the company are either reinvested internally or distributed as dividends.

Infinite Life: The company has an infinite or a very long life.

Where,
P = market price per share
D = dividend per share
E = earnings per share
r = internal rate of return of the firm
k = cost of capital of the firm
Explanation:
The mathematical equation indicates that the market price of the company’s share is the total of
the present values of:
◦ An infinite flow of dividends, and

◦ An infinite flow of gains on investments from retained earnings

The formula can be used to calculate the price of the share if the values of other variables are
available.
Criticism of Walter’s Model
Walter’s theory is critiqued for the following unrealistic assumptions in the model:

No External Financing: Walter’s assumption of complete internal financing by the firm through
retained earnings is difficult to follow in the real world. The firms do require external financing
for new investments.

Constant r and k: It is very rare to find the internal rate of return and the cost of capital to be
constant. The business risks will definitely change with more investments which are not
reflected in this assumption.
 Implication of Walter’s Model
Walter’s model has important implications for firms in various levels of growth as described below:

Growth Firm: Growth firms are characterized by an internal rate of return > cost of the capital i.e. r > k. These firms will have surplus profits
to invest. Because of this, the firms in growth phase can earn more return for their shareholders in comparison to what the shareholders
can earn if they reinvested the dividends. Hence, for growth firms, the optimum payout ratio is 0%.

Normal Firm: Normal firms have an internal rate of return = cost of the capital i.e. r = k. The firms in normal phase will make returns equal
to that of a shareholder. Hence, the dividend policy is of no relevance in such a scenario. It will have no influence on the market price of the
share. So, there is no optimum payout ratio for firms in the normal phase. Any payout is optimum.

Declining Firm: Declining firms have an internal rate of return < cost of the capital i.e. r < k. Declining firms make returns that are less than
what shareholders can make on their investments. So, it is illogical to retain the company’s earnings. In fact, the best scenario to maximize
the price of the share is to distribute entire earnings to their shareholders. The optimum dividend payout ratio, in such situations, is 100%.
Gordon’s theory on dividend policy
Gordon’s theory on dividend policy is one of the theories believing in the ‘relevance of
dividends’ concept.

• It is also called as ‘Bird-in-the-hand’ theory that states that the current dividends are
important in determining the value of the firm.

• Gordon’s model is one of the most popular mathematical models to calculate the market value
of the company using its dividend policy.
• Myron Gordon’s model explicitly relates the market value of the company to its dividend
policy. The determinants of the market value of the share are the perpetual stream of future
dividends to be paid, the cost of capital and the expected annual growth rate of the company.

• The Gordon’s theory on dividend policy states that the company’s dividend payout policy and
the relationship between its rate of return (r) and the cost of capital (k) influence the market
price per share of the company
 ASSUMPTIONS OF GORDON’S
MODEL
• No Debt: The model assumes that the company is an all equity company, with no proportion of debt in the capital structure.

• No External Financing: The model assumes that all investment of the company is financed by retained earnings and no external financing is required.

• Constant IRR: The model assumes a constant Internal Rate of Return (r), ignoring the diminishing marginal efficiency of the investment.

• Constant Cost of Capital: The model is based on the assumption of a constant cost of capital (k), implying the business risk of all the investments to

be the same.

• Perpetual Earnings: Gordon’s model believes in the theory of perpetual earnings for the company.

• Corporate Taxes: Corporate taxes are not accounted for in this model.

• Constant Retention Ratio: The model assumes a constant retention ratio (b) once it is decided by the company. Since the growth rate (g) = b*r, the

growth rate is also constant by this logic.

• K>g: Gordon’s model assumes that the cost of capital (k) > growth rate (g). This is important for obtaining the meaningful value of the company’s

share.
Valuation Formula And Its Denotations
Gordon’s formula to calculate the market price per share (P) is

P = {EPS * (1-b)} / (k-g)

Where,
◦ P = market price per share

◦ EPS = earnings per share

◦ b= retention ratio of the firm

◦ (1-b) = payout ratio of the firm

◦ k = cost of capital of the firm

◦ g = growth rate of the firm = b*r

The Gordon’s model can also be used to calculate the cost of equity, if the market value is known
and the future dividends can be forecasted.
Implications
• Growth Firm: A growth firm’s internal rate of return (r) > cost of capital (k). It benefits the shareholders more if the
company reinvests the dividends rather than distributing it. So, the optimum payout ratio for growth firms is zero.

• Normal Firm: A normal firm’s internal rate of return (r) = cost of the capital (k). So, it does not make any difference
if the company reinvested the dividends or distributed to its shareholders. So, there is no optimum dividend payout
ratio for normal firms. • However, Gordon revised this theory later and stated that the dividend policy of the firm
impacts the market value even when r=k. Investors will always prefer a share where more current dividends are
paid.

• Declining Firm: The internal rate of return (r) < cost of the capital (k) in the declining firms. The shareholders are
benefitted more if the dividends are distributed rather than reinvested. So, the optimum dividend payout ratio for
declining firms is 100%.
Criticism of Gordon’s Model
Gordon’s theory on dividend policy is criticised mainly for the unrealistic assumptions made in
the model.

Constant Internal Rate of Return and Cost of Capital: The model is inaccurate in assuming that r
and k always remain constant. A constant r means that the wealth of the shareholders is not
optimized. A constant k means the business risks are not accounted for while valuing the firm.

No External Financing: Gordon’s belief of all investments being financed by retained earnings is
faulty. This reflects sub-optimum investment and dividend policies.
Reference
Financial Management by I.M. Pandey, Vikas Publication

Rajiv Srivastava, Anil Misra, Financial Management, Oxford Publication

Khan and Jain, Financial Management, McGraw Hill

Brigham and Ehrhardt, Financial Management, Cengage Learning

R M Srivastava, Financial Management and Policy, Himalaya Publishing House

Prasanna Chandra, Financial Management Theory and Practice, McGraw Hill