According to this approach dividend policy always affects the value of the enterprise. A Mathematical formula is suggested to evolve dividend policy with a view to maximise the wealth position of equity shareholder. This is based on the relationship between the firm's-
1.Return the investment or IRR ( i.e. R ) and
2.Cost of capital or required rate of return ( i.e. K )
According to this approach if R>K the firm can earn higher return on their investment and firm should retain the earnings. Such firms are turned are as growth oriented firms and in their case, the optimum dividend policy would be to plough back the entire earnings.
In case of firm which does not have profitable investment opportunity i.e. R<K the optimum dividend policy would be to distribute the entire earnings as dividend. The shareholders will stand to gain because they can utilize the dividends so received in channels which can give them higher return.In case of firms where R = K, it does not matter whether the firm retains or distributes its earnings. In this case the value of the firm's share would not fluctuate with change in the dividend rates.
Mathematical Formula:
D = Dividend per share
E = Earnings per share
k = Cost of equity capital or market capitalisation rate
R = Internal rate of return or Internal productivity rate
Assumption of Walter's model:
I. The firm does the entire financing through retained earnings. It does not use external sources of funds such as new debt or new equity capital.
II. The firm has a very long life.
III. The firm's business risk does not change with additional investment. It implies the firm's IRR and cost capital remain cinstant.
1.Return the investment or IRR ( i.e. R ) and
2.Cost of capital or required rate of return ( i.e. K )
According to this approach if R>K the firm can earn higher return on their investment and firm should retain the earnings. Such firms are turned are as growth oriented firms and in their case, the optimum dividend policy would be to plough back the entire earnings.
In case of firm which does not have profitable investment opportunity i.e. R<K the optimum dividend policy would be to distribute the entire earnings as dividend. The shareholders will stand to gain because they can utilize the dividends so received in channels which can give them higher return.In case of firms where R = K, it does not matter whether the firm retains or distributes its earnings. In this case the value of the firm's share would not fluctuate with change in the dividend rates.
Mathematical Formula:
E = Earnings per share
k = Cost of equity capital or market capitalisation rate
R = Internal rate of return or Internal productivity rate
Assumption of Walter's model:
I. The firm does the entire financing through retained earnings. It does not use external sources of funds such as new debt or new equity capital.
II. The firm has a very long life.
III. The firm's business risk does not change with additional investment. It implies the firm's IRR and cost capital remain cinstant.
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