Walter and Gordon

Topics: Investment, Rate of return, Time value of money Pages: 6 (1616 words) Published: April 3, 2011
The term dividend refers to that part of profits of a company which is distributed by the company among its shareholders. It is the reward of the shareholders for investments made by them in the shares of the company. The investors are interested in earning the maximum return on their investments and to maximize their wealth. A company, on the other hand, needs to provide funds to finance its long-term growth. If a company pays out as dividend most of what it earns, then for business requirements and further expansion it will have to depend upon outside resources such as issue of debt or new shares. Dividend policy of a firm, thus affects both the long-term financing and the wealth of shareholders. As a result, the firm’s decision to pay dividends must be reached in such a manner so as to equitably apportion the distributed profits and retained earnings. Since dividend is a right of shareholders to participate in the profits and surplus of the company for their investment in the share capital of the company, they should receive fair amount of the profits. The company should, therefore, distribute a reasonable amount as dividends (which should include a normal rate of interest plus a return for the risks assumed) to its members and retain the rest for its growth and survival.

The value of the firm can be maximized if the shareholders wealth is maximized. There are conflicting views regarding the impact of dividend decision on the valuation of the firm. According to one school of thought dividend decision does not affect the share-holders’ wealth and hence the valuation of the firm. On the other hand, according to the other school of thought, dividend decision materially affects the shareholders’ wealth and also the valuation of the firm. We have discussed below the views of the two schools of thought under two groups:

a.The Relevance Concept of Dividend or the Theory of Relevance. b.The Irrelevance Concept of Dividend or the Theory of Irrelevance The Relevance Concept of Dividends : According to this school of thought, dividends are relevant and the amount of dividend affects the value of the firm. Walter, Gordon and others propounded that dividend decisions are relevant in influencing the value of the firm. Walter argues that the choices of dividend policies almost and always affect the value of the enterprise. The Irrelevance Concept of Dividend : The other school of thought propounded by Modigliani and Miller in 1961. According to MM approach, the dividend policy of a firm is irrelevant and it does not affect the wealth of the shareholders. They argue that the value of the firm depends on the market price of the share; the dividend decision is of no use in determining the value of the firm.

Walter’s model, one of the earlier theoretical models, clearly indicates that the choice of appropriate dividend policy always affects the value of the enterprise. Professor James E. Walter has very scholarly studied the significance of the relationship between the firm’s internal rate of return, r, (or actual capitalization rate) and its Cost of Capital, Ke (normal capitalization rate) in determining such dividend policy as will maximize the wealth of the stockholders.

Water’s model is based on the following premises:
(1) The firm finance its entire investments by means of retained earnings. New equity stock or debenture is not issued to raise funds.
(2) Internal rate of return (r) and cost of capital (Ke) of the firm remain constant. (3) The firm’s earnings are either distributed as dividends or reinvested internally. (4) Earnings and dividends of the firm never change.

(5) The firm has long or infinite life.
The formula used by Walter to determine the market price per share is

The formula used by Walter to determine the market price per share is :

P= D+r/K(-E)
P = Market price per share
D = Dividend per share
E = Earnings per...
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