Management is to maximise shareholders wealth
–
market price of equity shares
–
the
relationship
between the
dividend policy
&
market price
of equity shares
needs
to be understood

Dividend
policy
Some of the key dividend theories/ positions are:
Walter Model
Gordan model
MM model

Walter
Model
James
Walter has proposed a model of share valuation which supports
the view that
the dividend policy of the firm has a bearing on share
valuation
Assumptions
:
The firm is an all equity financed entity.
Further, it will rely only on
retained earnings to finance its future investments
The rate of return on investments is constant
Firm has an infinite life

Walter
Model
Based on the above assumptions, Walter put
forward the following valuation formula:
where
P =
price per equity share
D = dividend per share
E = Earnings per share
r = cost of capital
RoI = Return on investments
PV of infinite stream of
Retained
earnings
PV of infinite stream of
dividends
r
r
RoI
D
E
D
P
r
r
RoI
D
E
r
D
P

Implications of Walter model:
When the rate of return is greater than the cost of capital (RoI > r), the
price per share increases as the dividend payout ratio decreases. Optimal
payout ratio is
NIL
When the rate of return is equal to the cost of capital
(RoI = r), the
price per share does not vary with changes
in
dividend payout ratio.
Optimal
payout ratio
is
Irrelevant
When the rate of return is lesser than the cost of capital (RoI < r), the price
per share increases as the dividend payout ratio increases. Optimal
payout ratio is
100%

Gordon
Model
Assumptions
:
The firm will rely only on retained earnings to finance its future
investments
The rate of return on investments is constant
Growth rate of the firm is the product of its retention ratio (b) &
its rate of return
Cost of capital for the firm is constant
Firm has an infinite life
Taxes
are absent

Gordon
Model
Based on the above assumptions, Gordon put
forward the following valuation
formula:
where
P0 =
price per equity share at the end of year 0
E1 = Earnings per share at the end of year 1
r = rate of return expected by investors
RoI = Rate of return on investments
b
=
plough back ratio
E
1
( 1 - b)
r - ( RoI x b )
P
0
=

Implications
of
Gordon model
When RoI > r, Optimal
payout ratio
is
NIL
When
RoI = r, Optimal
payout ratio
is
Irrelevant
When
RoI < r, Optimal
payout ratio
is
100%