Question

Capitalization rate of equity (Ke)  =  10%
•       Earnings Per Share   =   Rs. 15
•       Assumed rate of Return on Investments (r)
•       Case 1.  15%
•       Case 2.   8%
•       Case 3.   10%
•       Compute the value of share assuming the payout of 0%, 50% and 100% under each of the r given above with Walter Model​

Answer 1

You should make the problem clear.

P = D/k + {r*(E-D)/k}/k

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.

IMPLICATIONS 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 profitable opportunities 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 somewhere else. 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%.

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