Question 4 (a)

Walter's model: determining the optimum dividend policy

5 marks

Time to write
About 10 minutes

From an older CBCS paper

Question

Question 4 (a) · 5 marks

4 (a) Under Walter's model, how is the optimum dividend policy determined?

Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Before you write

Read off the question and its marks

10 minfor 5 marks

Write it in this order

  1. Read; underline the asks; jot your points 1 min
  2. 1 The model and formula 1½ marks 2 min
  3. 2 Optimum payout for growth, declining and normal firms 2½ marks 4 min
  4. 3 Assumptions and limitation 1 mark 2 min
  5. Check: every ask answered, key terms underlined 1 min

Short on time? Trim steps 1 and 2 evenly rather than skip one: each is capped at its own marks. End with step 3 in a line or two.

Try it first. About 10 minutes for 5 marks. Write it out, then open the solution.

Solution

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

The model. Walter holds that dividend policy affects the value of the share, and that the optimum policy depends on the relationship between the firm's rate of return on investment (r) and its cost of capital, the return shareholders require (k). The share's value is

P = [D + r(E − D) ÷ ke] ÷ ke,

where D is the dividend per share and E the earnings per share.

Determining the optimum payout

  1. Growth firm (r > k): retained earnings earn more than shareholders require, so the firm should retain its earnings; the optimum payout is zero, which maximises the value of the share.
  2. Declining firm (r < k): shareholders gain if the earnings are distributed; the optimum payout is 100%.
  3. Normal firm (r = k): the dividend policy does not affect the value of the share; there is no optimum payout.

Assumptions. Investment financed only by retained earnings; constant r and k; constant earnings and dividends; a perpetual life. The model is criticised because firms do use external finance and r and k change as investment grows, so its "all or nothing" optimum is a guide rather than a rule.

Where the 5 marks sit

#ComponentMarks
1The model and formula1.5
2Optimum payout for growth, declining and normal firms2.5
3Assumptions and limitation1
Total5
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