Walters model supports the principle that dividends are relevant. The investment policy of a firm cannot be separated from its dividend policy and both are inter-related. The choice of an appropriate dividend policy affects the value of an enterprise.
Retained earnings are the only source of finance. This means that the company does not rely upon external funds like debt or new equity capital.
The firms business risk does not change with additional investments undertaken. It implies that r(internal rate of return) and k(cost of capital) 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.
Equation showing the value of a share (as present value of all dividends plus the present value of all capital gains) Walters model:
, the value of shares is inversely related to the D/P ratio. As the D/P ratio increases, the market value of shares decline. Its value is the highest when D/P ratio is 0. So, if the firm retains its earnings entirely, it will maximize the market value of the shares. The optimum payout ratio is zero.
, the D/P ratio and the value of shares are positively correlated. As the D/P ratio increases, the market price of the shares also increases. The optimum payout ratio is 100%.
, the market value of shares is constant irrespective of the D/P ratio. In this case, there is no optimum D/P ratio.
Walters model assumes that the firms investments are purely financed by retained earnings. So this model would be applicable only to all-equity firms.
The assumption of r as constant is not realistic.
The assumption of a constant ke ignores the effect of risk on the value of the firm.
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