## Walter's Model – Assumptions, Advantages & Limitations
Walter's Model explains how dividend policy affects the market value of a firm's shares. The central idea: the relationship between the firm's internal rate of return (r) and the cost of equity (Ke) determines whether retaining or distributing earnings maximises share value.
### Decision Rule
| Condition | Firm Type | Optimal Policy |
|---|---|---|
| r > Ke | Growth firm | Retain all earnings (zero dividend) |
| r < Ke | Declining firm | Distribute all earnings (100% dividend) |
| r = Ke | Normal firm | Dividend policy is irrelevant |
### Assumptions
| Assumption | Detail |
|---|---|
| Internal Financing Only | All investments financed solely through retained earnings — no external equity or debt |
| Constants | r (rate of return) and Ke (capitalisation rate) remain constant forever |
| Perfect Capital Markets | Investors are rational; information is freely and equally available to all |
| No Tax Differential | Dividend income and capital gains are taxed identically |
| No Flotation/Transaction Cost | Issuing shares or paying dividends incurs zero transaction cost |
| Infinite Life | The firm operates indefinitely |
### Advantages
1. Simple and easy to compute – straightforward formula with minimal inputs.
2. Considers key variables – explicitly links r, Ke, and dividend payout ratio to determine share value.
### Limitations
1. Ignores real-world factors – taxation, legal restrictions on dividends, and management policies are excluded.
2. Ke is hard to estimate precisely – the exact market capitalisation rate is difficult to determine.
3. Unrealistic assumptions – zero tax and perfect markets do not exist in practice.