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The Walter and Gordon Models are two classic dividend policy models that provide insights into the relationship between a firm’s dividend policy and its valuation. These models were developed by James E. Walter and Myron J. Gordon, respectively.

Walter’s Model:

Assumptions:

  1. The firm is an all-equity firm, meaning it has no debt.
  2. The cost of equity (Ke) is constant.
  3. The firm has profitable investment opportunities (internal rate of return on investments is higher than the cost of equity).

Formula:

P0=DKe+ERKe

Where:

  • is the price per share.
  • is the dividend per share.
  • is the earnings per share.

  • is the retention ratio (


    1Dividend Payout Ratio

    ).

  • is the cost of equity.

Explanation: Walter’s model suggests that the value of a firm is determined by the relationship between the firm’s dividend policy and its ability to reinvest earnings profitably. According to the model, if the rate of return on internal investments (Ke) is greater than the cost of equity, retaining earnings (and not paying dividends) will increase the value of the firm.

Gordon’s Model:

Assumptions:

  1. The firm follows a constant dividend payout ratio.
  2. The cost of equity (Ke) is constant.
  3. The dividend growth rate (g) is constant.

Formula:

P0=P
0
(1+g)
Keg

Where:

  • is the price per share.

  • is the most recent dividend per share.

  • is the cost of equity.
  • is the constant dividend growth rate.

Explanation: Gordon’s model is a variant of the Gordon Growth Model (or Dividend Discount Model) that assumes a constant dividend growth rate. It suggests that the value of a firm is directly related to the dividend per share and the rate of dividend growth. The model is often used for companies with a stable dividend payout policy.

Key Differences:

  1. Earnings Retention:
    • Walter’s model emphasizes the impact of earnings retention on the value of the firm, suggesting that retaining earnings can lead to increased value.
    • Gordon’s model focuses on the relationship between the current dividend and its expected growth rate, assuming a constant dividend payout ratio.
  2. Investment Opportunities:
    • Walter’s model assumes that the firm has profitable investment opportunities, and retaining earnings is a way to finance those opportunities.
    • Gordon’s model is more focused on the dividend payout ratio and the sustainable growth rate in dividends.
  3. Dividend Growth Rate:
    • Walter’s model does not explicitly incorporate a constant dividend growth rate.
    • Gordon’s model explicitly includes a constant dividend growth rate as a key factor.

Both models provide valuable insights into the relationship between dividend policy and firm valuation. However, it’s important to note that these models have certain simplifying assumptions and may not fully capture the complexities of real-world financial scenarios.