Walter's Model answers one of the most debated questions in finance: does it matter how much dividend a company pays? Walter says — yes, it absolutely does, but only because of what the company can do with the money it keeps.
The core logic is simple: if your company earns a higher return on reinvested profits (called r, the internal rate of return) than what shareholders expect (called Ke, the cost of equity or capitalisation rate), then shareholders are better off letting the company keep the money. Conversely, if the company can't beat shareholder expectations, pay it all out. This comparison between r and Ke is the entire engine of Walter's Model.
Walter gives us a formula to find the market price per share (P):
P = (D + (r / Ke) × (E − D)) / Ke
where E = Earnings per share, D = Dividend per share, r = firm's internal rate of return, Ke = cost of equity. The term (E − D) is simply the retained earnings per share. Three types of firms emerge from this: Growth firms (r > Ke) — zero dividend maximises price; Declining firms (r < Ke) — 100% payout maximises price; Normal firms (r = Ke) — dividend policy is irrelevant, price stays the same regardless of D.
The model rests on key assumptions you must know for MCQs: (1) only internal financing — no new equity or debt is raised; (2) r and Ke are constant forever; (3) the firm has an infinite life; (4) all earnings are either fully paid as dividend or fully retained. These assumptions are also the model's criticisms — in reality, r declines as more is invested, Ke changes with risk, and companies do raise external funds. This is asked frequently as a 4–6 mark question in FM, either as a numerical (find P under different dividend policies) or a theory question (state assumptions/limitations).