# Walter's Model
Walter's Model is a relevance theory — it holds that the dividend decision affects the market price of a share. Its central idea: the relationship between the firm's return on investment (r) and its cost of equity (Ke) determines the optimum payout.
## A. Assumptions
- EPS and DPS remain constant.
- r (rate of return) and Ke (cost of capital) are constant.
- The firm has a perpetual life.
- Perfect capital markets — all investors are rational and information is freely available.
- No taxes.
- No floatation or transaction costs.
## B. Walter's Formula
$$P_0 = \frac{D}{K_e} + \frac{r(E - D)}{K_e^{\,2}}$$
Where:
- P₀ = Price of share today
- D = Dividend per share
- E = Earnings per share
- Ke = Cost of equity / expected return / capitalization rate / discount rate
- r = Return on investment / return on equity / IRR
- (E − D) = Retained earnings per share
Reading the formula: the first term is the value of the dividend stream; the second term is the value created by retaining and reinvesting (E − D) at rate r.
## C. Optimum Dividend Payout under Walter's Model
Decisions are made by comparing Ke (investor's expectation) with r (return earned by the company):
| Type of Firm | Condition | Dividend ↔ Market Price | Optimum Payout |
|---|---|---|---|
| Growth | r > Ke | Negative correlation | 0% (retain everything) |
| Constant | r = Ke | No correlation | Every payout ratio is optimum |
| Decline | r < Ke | Positive correlation | 100% (pay everything out) |
The logic: If the firm earns more than investors expect (r > Ke), it should retain and reinvest — paying dividends would lower value (negative correlation), so optimum payout = 0%. If the firm earns less than investors expect (r < Ke), shareholders are better off taking the cash and investing elsewhere, so optimum payout = 100%.
> Doubt Buster: Both Walter's Model and Gordon's Model prescribe the same optimum dividend payout criteria (0% for growth, 100% for declining firms).