Essence of Walters Model

Dividends paid to the shareholders are re-invested by the shareholder further, to get higher
returns. This is referred to as the opportunity cost of the firm or the cost of capital, ke for the
firm. Another situation where the firms do not pay out dividends is when they invest the profits
to earn returns on such investments. This rate of return r, for the firm must at least be equal to ke.
If this happens then the returns of the firm is equal to the earnings of the shareholders if the
dividends were paid. Mainly Walters model says about 3 basic things:
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If r<ke then the firm should distribute the profits in the form of dividends to give the

shareholders higher returns.

If r>ke then the investment opportunities reap better returns for the firm and thus, the

firm should invest the retained earnings.

And when r = k then the dividend has no effect.

Limitations of Walters model

The Walter's model, one of the earliest theoretical models, explains the relationship between
dividend policy and value of the firm under certain simplified assumptions.
1) The Walter's model assumes that the firm's investments are financed exclusively by retained
earnings; But there is no external financing is used.
2) The model assumes that r is constant. This is not a realistic assumption because when
increased investments are made by the firm, r also changes.
3) The assumption of constant, ke, the risk complexion of the firm has a direct bearing on it. By
assuming a constant ke, Walter's model ignores the effect of risk on the value of the firm.

Essence of Gordons Model

Investors are risk averse and believe that incomes from dividends are certain rather than incomes
from future capital gains, therefore they predict future capital gains to be risky propositions.
They discount the future capital gains at a higher rate than the firm's earnings thereby, evaluating
a higher value of the share. In short, when retention rate increases, they require a higher
discounting rate. Gordon has given a model similar to Walter's where he has given a
mathematical formula to determine price of the share.

Home Made Dividend

Homemade Dividend means dividend created by a stockholder through selling a portion of
shares held. Its an opposition to a dividend received from the company that issued the stock. If
investors want an income from their stocks, even if the company does not declare a dividend,
they can sell a portion of their shares.
For example if a stockholder owns 1000 shares, he can sell 10 shares to receive money equal to
1% dividend. After the sale the value of his stocks will be 1% less, but that would have been the
same if the company had declared 1% dividend, because that also reduces the stock price.

"BIRD-IN-HAND".

This argument holds that future earnings are less predictable and more uncertain than dividends,
at least because they are further in the future. The greater uncertainty of future earnings should
be reflected in a higher discount rate on capital gains than on dividends. This in turn would
cause investors to prefer a more certain $1.00 of dividends over a less certain $1.00 of future
earnings.