What are the essentials of Walter's Dividend Model?

Finance ManagementBanking & FinanceGrowth & Empowerment

Walter's model is one of the most important theories of dividend in financial management. Proposed by Professor James E. Walter, the model states that the dividend policy is a precursor of the value of a company. As companies pay dividends depending on the earnings, the payout of dividends can show how much the company was valued.

Walter's model is based on the relationship between a company's Internal Rate of Return (IRR) and the Cost of Capital (CoC). These two factors are used to find the dividend theory that will reflect the want of the company to maximize the shareholder's wealth. As increasing the shareholder wealth is an objective of most corporate firms, it is a key policy that shows how dividend payout influences the valuation of a firm.

Formula for Walter's Model

The formula that is used to determine the market price per share with Walter's model is,

$$P\:=\:\frac{D+\frac{r}{k}(E-D)}{k}$$

Where,

  • P = Market Price of share

  • D = Dividend per share

  • E = Earnings per share

  • r = Internal rate of return

  • k = cost of capital

Criticism of Walter's Dividend Model

Walter's theory is based on some principles like most other theories, and among all other dividend policy theories, it is the best. However, the theory is not free from criticism.

  • As the theory considers the entire amount of dividend to be retained or distributed, it is a theory that is not quite practical in nature.

  • Walter's theory also requires the Cost of Capital and the Internal Rate of Return to be constant which is impractical in nature.

  • Walter's model also considers that starting earnings and dividends never change. However, Earnings Per Share (EPS) and Dividend Per Share may change.

  • To be considered under Walter's model, a company must have an infinite life, which is quite impractical to assume.

As mentioned above, Walter's Model uses the Internal Rate of Return and Cost of Capital to determine the dividend policy of a firm. It is an excellent way to calculate the valuation of a firm. Theoretically, Walter's model has no flaws because it considers all aspects related to the dividend policy of a firm. However, in terms of regular and practical use cases, it is rigid and cannot be used to determine the true dividend policy.

Conclusion

In brief, Walter's dividend policy model is a great theoretical model to determine the value of a firm using IRR and the Cost of Capital. However, it is not applicable in many practical situations. Therefore, one must understand the difference between theoretical and practical use cases before using Walter’s model.

raja
Updated on 03-Mar-2022 10:29:04

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