Walter s Valuation Modely Prof. James E Walter argued that in the long-run the

share prices reflect only the present value of expected dividends. Retentions influence stock price only through their effect on future dividends. Walter has formulated this and used the dividend to optimize the wealth of the equity shareholders.

Formula of Walter s ModelP= D + r (E-D) k k

Where, P = Current Market Price of equity share E = Earning per share D = Dividend per share (E-D)= Retained earning per share r = Rate of Return on firm s investment or Internal Rate of Return k = Cost of Equity Capital

Assumptions of Walter s Modely All financing is done through retained earnings and external sources of funds like debt or new equity capital are not used. Retained earnings represents the only source of funds. y With additional investment undertaken, the firm s business risk does not change. It implies that firm s IRR and its cost of capital are constant. y The return on investment remains constant. y The firm has an infinite life and is a going concern. y All earnings are either distributed as dividends or invested internally immediately. y There is no change in the key variables such as EPS or DPS.

Effect of Dividend Policy on Value of ShareCase 1. In case of Growing firm i.e. where r > k 2. In case of Declining firm i.e. where r < k 3. In case of normal firm i.e. where r = k If Dividend Payout ratio Increases Market Value of Share decreases Market Value of Share increases No change in value of Share If Dividend Payout Ration decreases Market Value of a share increases Market Value of share decreases No change in value of Share

Criticisms of Walter s Modely No External Financing y Firm s internal rate of return does not always remain

constant. In fact, r decreases as more and more investment in made. y Firm s cost of capital does not always remain constant. In fact, k changes directly with the firm s risk.

Illustration 1 (In case of Growing Firm)y The earnings per share of a company are Rs. 10. The

Equity Capitalization rate is 10%. Internal Rate of return on retained earnings is 20%. Using Walter s formula:y What should be the optimum payout ratio of the

company? y What should be the price of share at optimum payout ratio? y How shall this price be affected if different payout (say 80%) were employed?

Illustration 2 (In case of Normal Firm)y The earnings per share of a company are Rs. 10. The

Equity Capitalization rate is 10%. Internal Rate of return on retained earnings is 10%. Using Walter s formula:y What should be the optimum payout ratio of the

company? y What should be the price of share at optimum payout ratio? y How shall this price be affected if different payout (say 80%) were employed?

Illustration 3 (In case of Declining Firm)y The earnings per share of a company are Rs. 10. The

Equity Capitalization rate is 20%. Internal Rate of return on retained earnings is 10%. Using Walter s formula:y What should be the optimum payout ratio of the

company? y What should be the price of share at optimum payout ratio? y How shall this price be affected if different payout (say 80%) were employed?

Illustration 4y The earning per share of a company are Rs. 10 and the

rate of capitalization applicable to it is 10%. The company has before it the option of adopting a payout of 20% or 40% or 80%. Using Walter s formula, compute the market value of the company s share if the productivity of retained earning is (a) 20% (b) 10% and (c) 8%. What inference can be drawn from the above exercise?