What are the limitations of Walter’s Theory on Dividend Policy?

Banking & FinanceFinance ManagementGrowth & Empowerment

According to Walter’s Model, dividends are relevant and have a bearing on a company's share prices. It also advocates that the investment policy is interlinked with the dividend policy and the two cannot be separated.

Walter's Dividend Theory is based on some assumptions that are needed to exactly classify the theory. However, some of these assumptions make the theory too rigid.

Limitations of Walter's Dividend Theory Model

Here are the limitations of Walter’s dividend theory model −

No External Financing

Walter’s model considers that the dividends of a company are paid using 100% retained earnings and no external financing - equity or debt is used for it. However, in practice, it is nearly impossible to fund a project that does not rely on external debt or equity as funds.

In order to make a project external investment-free, the firm’s dividend policy or investments should be sub-optimum. However, applying Walter’s model on dividends distributed makes the process optimum level. So, Walter’s Model is contradictory to its own nature.

It's Not Practical in the Real World

It is impossible to think about a zero external funded project in reality. Although Walter’s model described the dividend management process debt and equity free, there is hardly any project in the real world of such kind. Companies often use debt or equity to finance their projects. So, getting an ideal project that is debt and equity free is nearly impossible to find in the real world.

Constant Rate of Return

Walter’s model assumes that the internal rate of return of an investment project is required to describe its dividend policy for evaluating its valuation. However, this assumption is erroneous in nature. It’s impossible to find constant internal rates of return in real-world projects.

In practice, the internal rate of return goes down with decreasing investments. Therefore, finding an ideal investment project where poorer projects provide equally high returns as the richer ones is an unrealistic assumption.

Constant Opportunity Cost of Capital

Walter’s model assumes that all projects of a company must have equal opportunity cost of capital. That means the risk associated with investments made in different projects remains the same irrespective on the nature of projects. By eliminating the reality that risks for different projects are different in nature and amount, Walter’s model proposes an idea that is impossible to realize in the real-world scenario.

Conclusion

Walter’s model, despite its limitations, is a widely used model to determine the dividend policies of all equity investment projects. However, some changes to the model are required to make it error-free and practical in nature. We can, however, learn a lot about dividend theory and their outcomes by using Walter’s model in general and that is why it is a good recommendation for investment projects generally.

raja
Updated on 25-Mar-2022 05:41:44

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