Walter’s model explains dividend policy clearly. James E. Walter proposed it in 1963. This model links dividends to firm value directly.
The model assumes perfect capital markets. It rejects external financing needs. Firms fund investments through retained earnings only.
Walter uses a simple formula. Firm value depends on return on investment (r) and cost of capital (k). Dividends affect value based on this relationship.
Three key situations emerge. First, when r > k, the firm should retain all earnings. Retaining profits increases shareholder wealth significantly. Consequently, zero dividend payout maximizes value.
Second, when r < k, the firm should distribute all earnings as dividends. Retention destroys value in this case. Thus, 100% payout becomes optimal.
Third, when r = k, dividend policy remains irrelevant. Shareholders gain the same value either way. Payout ratio does not affect firm value here.
Walter emphasizes internal growth opportunities. High-return projects justify low dividends. Poor opportunities favor generous payouts instead.
Critics point out limitations quickly. The model ignores taxes completely. It assumes no external equity financing. Real-world imperfections challenge these assumptions.
Nevertheless, Walter’s model offers valuable insights. It highlights the trade-off between dividends and reinvestment. Managers use it to guide payout decisions wisely.
Overall, Walter’s approach stresses opportunity cost. Dividends matter when investment returns fall short. Retain earnings only for superior projects. This simple logic guides financial strategy effectively.