CA Intermediate · Financial Management and Strategic Management · Dividend Decision
Under Walter's model, a firm has a return on investment (r) greater than its cost of capital (k). Which dividend payout policy maximises the market value of its shares?
The optimal payout is zero. In Walter's model a growth firm with r greater than k earns more on retained earnings than shareholders can elsewhere, so retaining all profits raises share value. Full payout suits firms where r is below k.
- AA 100% payout ratio
- BA 50% payout ratio
- CA zero payout ratioCorrect
- DA payout equal to the industry average
Explanation
In Walter's model, when r exceeds k the firm is a growth firm and earns more on retained funds than shareholders could earn elsewhere. Value is therefore maximised by retaining all earnings, i.e. zero payout. A 100% payout is optimal only when r is less than k.
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