Walter's model VS Market price of the share

Walter model was developed by the professor James E. Walter. He indicates in his model that the choice of appropriate dividend policy affects the value of the enterprise.In a sense,it implies that dividend affects the value of enterprise. He also studied the significance of the relationship between the firm’s internal rate of return (r) and cost of capital (ke) in determining such dividend policy which will accumulate the wealth of the shareholders.

He throws some assumption while dealing with it. These are-  1-Retained earnings should be source of finance which means a company doesn’t depend on external funds.

 2-The business risk should not change with additional investment undertaken that implies cost of capital and internal rate of return are constant.

 3-Earnings per share (E) and dividend per share (D) should be constant as assumed.

4-The firm has long and infinite life.

 Walter’s model for market price per share (p) computation-

P                   = D/ke+[r/Ke(E-D)]/Ke

He draws following conclusion out of the Walter model. These are-

When r> Ke

The value of share is inversely related to dividend payout ratio. As dividend ratio increases, the value of shares decline. if firms retained its earning entirely which will increase the market value of the shares. Here, the optimum payout ratio is zero.

When r<Ke

Dividend payout ratio and value of shares are positively co-related. As the dividend payout ratio increases, the market price of the shares increase. Then dividend payout ratio is hundred percent.

When r=Ke

The market value of shares are constant irrespective to optimum payout ratio.