The dividend decision of the business concern is one of the crucial parts of the financial manager because it determines the amount of profit to be distributed among shareholders and the amount of profit to be treated as retained earnings for financing its long term growth. Hence, dividend decision plays a very important part in the financial management. Dividend decision consists of two important concepts which are based on the relationship between dividend decision and the value of the firm.
Professor James E. Walter has developed a theoretical model that shows the relationship between dividend policies and common stock prices. The basic premise underlying the formulation is that prices reflect the present value of the expected dividend in the long run. The model operates on the objective of maximizing common stockholders’ wealth. In general, if a firm is able to earn a higher return on earnings retained than the stockholder is able to earn on a like investment then it would appear beneficial to retain these earnings, all other things being equal.
Walter’s model is based on the following assumptions:
- The firm finances all investment through retained earnings; that is debt or new equity is not issued;
- The firm’s internal rate of return (r), and its cost of equity capital (ke) are constant;
- All earnings are either distributed as dividends or reinvested internally immediately.
- Beginning earnings and dividends never change. The values of the earnings per share (E), and the dividend per share (D) may be changed in the model to determine results, but any given values of E and D are assumed to remain constant forever in determining a given value.
- The firm has a very long or infinite life.
According to the theory, the optimum dividend policy depends on the relationship between the firm’s internal rate of return and cost of capital. If r > ke, the firm should retain the entire earnings, whereas it should distribute the earnings to the shareholders in case the r < ke. The rationale of r > ke is that the firm is able to produce more return than the shareholders from the retained earnings.
Walter’s view on optimum dividend payout ratio can be summarised as below:
(a) Growth Firms (r > ke):- The firms having r > ke may be referred to as growth firms. The growth firms are assumed to have ample profitable investment opportunities. These firms naturally can earn a return that is more than what shareholders could earn on their own. So the optimum payout ratio for a growth firm is 0%.
(b) Normal Firms (r = ke):- If r is equal to k, the firm is known as the normal firm. These firms earn a rate of return that is equal to that of shareholders. In this case, the dividend policy will not have any influence on the price per share. So there is nothing like an optimum payout ratio for a normal firm. All the payout ratios are optimum.
(c) Declining Firm (r < ke):- If the company earns a return that is less than what shareholders can earn on their investments, it is known as a declining firm. Here it will not make any sense to retain the earnings. So entire earnings should be distributed to the shareholders to maximize the price per share. Optimum payout the ratio for a declining firm is 100%.