CA Intermediate · Financial Management and Strategic Management · Dividend Decision
Under Walter's model of dividend policy, a firm's market price per share is expected to be highest at a payout ratio of zero when the firm is a:
A growth firm, where return on investment exceeds the cost of capital, maximises share price at zero payout in Walter's model. Retained earnings earn more than shareholders could earn elsewhere, so full retention adds value. Dividend policy is irrelevant for normal firms and full payout is best for declining firms.
- AGrowth firm, where the return on investment (r) exceeds the cost of capital (Ke)Correct
- BNormal firm, where r equals Ke
- CDeclining firm, where r is less than Ke
- DFirm with no retained earnings available
Explanation
In Walter's model, if r > Ke the firm earns more on retained funds than shareholders could earn elsewhere, so retaining all earnings maximises value; the optimal payout is zero. For a normal firm payout is irrelevant, and for a declining firm (r < Ke) the optimal payout is 100%.
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