Dividend And Valuation – Walters Model

Nayan Satsangi - 46 Reshma Chore - 7Sneh Shukla - 50Kandarp Desai -11

Title

To Study the Dividend Policy Of Sensex Companies using Walters Model

Abstract

The dividend policy of a company determines what proportion of earnings is distributed to the shareholders by way of dividends, and what proportion is ploughed back for reinvestment purposes.

Since the main objective of financial management is to maximise the market value of equity shares, one key area of study is the relationship between the dividend policy and market price of equity shares.

According to Walter’s Model , the dividend policy of a firm depends upon the relationship between r(rate of return) & k(cost of capital).

If r>k (a case of a growth firm), the firm should have zero payout and reinvest the entire profits to earn more than the investors. If however, r<k, then the firm should have 100% payout ratio and let the shareholders reinvest their dividend income to earn higher returns, if ‘r’ happens to be just equal to ke, the shareholders will be indifferent whether the firm pays dividends or retain the profits. In such a case, the returns of the firm from reinvesting the retained earnings will be just equal to the earnings available to the shareholders on their investment of dividend income.

Abstract Contd…

The Walter’s model provides a theoretical and simple frame work to explain the relationship between policy and value of the firm. As far as the assumptions underlying the model hold well, the behaviour of the market price of the share in response to the dividend policy of the firm can be explained with the help of this model.

The limitation of this model is that these underlying assumptions are too unrealistic. The financing of investments proposals only by retaining earnings and no external financing is seldom found in real life.

The assumption of constant ‘r’ and constant ‘ke’ is also unrealistic and does not hold good. As more and more investment is made, the risk complexion of the firm will change and consequently the ke may not remain constant.

Dividend PolicyWhat is It?

Dividend refers to the corporate net profits distributed among shareholders.

Dividend Policy refers to the explicit or implicit decision of the Board of Directors regarding the amount of residual earnings that should be distributed to the shareholders of the corporation.

This decision is considered a financing decision because the profits of the corporation are an important source of financing available to the firm.

Introduction

The optimal dividend policy of a firm depends on investor’s desire for capital gains as opposed to

income their willingness to forgo dividend now for future

returns perception of the risk associated with

postponement of returns.

-Various firms adopt dividend policies depending on the company’s articles of association and the prevailing economic situation.

-Some make high pay out, while others make low pay out

-Yet others pay stock dividends (bonus issue) in lieu of or in addition to cash dividend

- While others pay cash only.

Walters Model

Walter’s model supports the doctrine that dividends are relevant. The investment policy of a firm cannot be separated from its dividends policy and both are, according to Walter, interlinked. The choice of an appropriate dividend policy affects the value of an enterprise.

Assumptions

All financing is done through retained earnings: external sources of funds like debt or new equity capital are not used.

With additional investments undertaken, the firm’s business risk does not change. It implies that r and k are constant.

There is no change in the key variables, namely, beginning earnings per share, E, and dividends per share, D. The values of D and E may be changed in the model to determine results, but, any given value of E and D are assumed to remain constant in determining a given value.

The firm has perpetual (or very long) life.

investment firms the on return of rate The rshare per Earnings Eshare per Dividend D

share a of price market prevailing The Pwhere

ek

DEekrD

P

P

DEekrD

e

k

Formula

Literature Review

Sr. No

Name of the Paper

Topic Author Brief about the Paper

1. Effects of Dividends on Stock Prices in Nepal

Rabindra Joshi

1.There is a significant effect of dividend policy on stock prices of the companies in both banking and non-banking sector. 2.Walter's model has 4 basic assumptions : a.Retained earnings are only source of finance available for a firm. b.Cost of capital and Rate of Returns are assumed to be constant and thus any additional investments made by firm will not change its risk profile. c.Firm has infinite life. d.DPS and EPS for a given value of the firm, remains constant 3.The Walters model explains the three possibilities : a.rate of return = cost of equity ->the dividend policy is irrelevant in deciding the value of the firm. b.rate of return < cost of equity -> 100% payout helps in increasing value of the firm. c.rate of return = cost of equity -> the firm can retain the earnings for further investments 4.According to various researches conducted by taking the stock prices if the companies as dependent variable and dividends per share,retained earnings per share,market price per share as dependent variable, it was found that dividends have a significant effect on the stock prices and the value of the firm. 5.Generally, people who come below the income tax range are interested in higher dividends whereas those with higher incomes prefer low dividends for tax purposes. 6.The retained earnings are not taxed until the earnings are realized.The shareholders enjoy tax advantage in retained earnings.

Sr No.

Name Topic Author Summary

The Level Of Corporate Dividend Pay out to Stockholders: Does Optimal Dividend Policy Exist For Firms Quoted At The Nairobi Stock Exchange?

To Study Dividend Policy of Sensex Companies using Walter's Model.

Bitok Kibet, Moi University, Kenya Tenai Joel, Moi University, Kenya Cheruiyot Thomas, Moi University, Kenya Maru Loice, Moi University, Kenya Kipsat Mary, Moi University, Kenya.

The objective of this study was to determine the level of corporate dividend payout to stockholders and establish if the optimal dividend policy exists for the firms quoted at the Nairobi Stock Exchange. The dividend model provides a summary of the factors that influenced and continue to influence the dividend decisions for this market including and not limited to the tax systems, clientele preferences, signaling, sustainability, low liquidity, high growth, ownership control and dividends as residual etc. From the model it is possible to predict the likely dividend decisions of the firms in future.

Sr No.

Name Topic Author Summary

Dividend Policy: A Review of Theories and Empirical Evidence.

To Study Dividend Policy of Sensex Companies using Walter's Model.

Husam-Aldin Nizar Al-Malkawi, Michael Rafferty, Rekha Pillai.

This paper aims at providing the reader with a comprehensive understanding of dividends and dividend policy by reviewing the main theories and explanations. The Basic Irrelevance Thesis Bird-In-The-Hand Hypothesis Tax-EffectHypothesis This paper began with an overview of the evolution of corporate dividend policy. It was noted that dividend policy has been bound up with the development and history of the corporation itself. The paper also presented the basic argument and M&M proof of dividend irrelevancy. The paper then explored the main theories that counter the irrelevancy proposition. In order to provide an understanding of dividend policy theories, attempted to explain the basic argument for each theory followed by the most important empirical evidence on testing of these theories.

Sr. No

Name of the Paper

Topic Author Brief about the Paper

 1  THE EFFECT OF DIVIDEND POLICY ON THE MARKET PRICE OF SHARES IN NIGERIA: CASE STUDY OF FIFTEEN QUOTED COMPANIES

 To study the dividend policy of Sensex Companies using Walters model.

 Dr. J. J. Adefila

-The objective of this research paper is to examine the possible effects that a firm’s dividend policy might have on the market price of its common stock and also, those factors that influence firm’s dividend policy in general. - The objective of the firm is to increase the wealth of its stockholders. Hence the best dividend policy is the one that increases shareholders wealth by the greatest amount. - Walters Model is a strategy that is used to study the Dividend policy of a company and its effect on the market share price.-It is based on : where the reinvestment rate, that is, rate of return that the company may earn on retained earnings, is higher than cost of equity then, it would be in the interest of the firm to retain the earnings. -If the company’s reinvestment rate on retained earnings is the less than shareholders’rate of return, the company should not retain earnings.-If the two rates are the same, then thecompany should be indifferent between retaining and distributing.

Methodology

We have taken the sample of the Sensex companies as our sample which includes 30 companies. We will be taking the Market share price as the independent variable and the other variables like dividend per share, earning per share and rate of return and independent variables.

We will be analysing the effect of the Walter’s Dividend Policy on the share prices of these sensex companies.

Data is obtained from : Money control Ace Equity Analyzer

Key Words

EPS Rate of Return Cost of Capital Dividends Payout Ratio

Data Analysis – HDFC Bank EPS : Rs. 22.02 r=17.26% D1 = 215%(Face Value = 2 Rs)

= Rs. 4.30 g = 10% Po =436.35 (Year 2011) Ke= 4.30/436.35 =

0.0098+0.10=.11

r>ke

P = 4.30 + .1726/.11(22.02-4.30).11

=Rs.291.85

Share Price – Year 2011= 436.35

Share Price - Year 2012 =Rs. 536

Assume r=ke & D=300%

EPS : Rs. 22.02 r=17.26% D1 = 300%(Face Value = 2 Rs)

= Rs. 6 g = 10% Po =436.35 (Year 2011) Ke=17.26%

P = 4.30 + .1726/.1726(22.02-4.30).1726

=Rs.127.59

D=400% P=Rs. 127.59

Data Analysis – Hero Motocorp Ltd.

Share Price : Rs. 2245 (As on 20th May 2012)

EPS : Rs. 119.09r = 55.43%D1 = 2250% (Face Value = 2 Rs) =

45 Rs.g = 22.22%Po = Rs.2245Ke = (45/2245) + .2222 = .2024

P = 45+ .5543/.2024(119.09 – 45).2024

Expected Price of Share in May 2013 = 887.20

Conclusion

The following assumptions do not hold true always :

1. No External Financing2. Constant rate of return,3. Constant Cost of Capital, k

References

I. M. Pandey “ Financial Management “

Moneycontrol.comAce Analyzerwww.money.rediff.com

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