CS Executive · Corporate Accounting and Financial Management · Dividend Decisions
According to Walter's model of dividend policy, which condition makes the dividend payout ratio irrelevant to the market price of a share?
Under Walter's model, dividend policy is irrelevant when the return on investment equals the cost of capital (r = k). Then retained earnings earn exactly what shareholders require, so the share price is E/k regardless of the payout ratio.
- AReturn on investment (r) equals cost of capital (k)Correct
- BReturn on investment (r) is greater than cost of capital (k)
- CReturn on investment (r) is less than cost of capital (k)
- DThe firm raises all new funds through external equity
Explanation
In Walter's model, P = [D + (r/k)(E - D)] / k. When r = k, the term r/k equals 1, so the price becomes E/k whatever the D. A growth firm (r > k) gains from retention, and a declining firm (r < k) gains from full payout.
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