Prof. James E. Walter has given a mathematical formulation to illustrate dividend policy as a financing decision, which depends solely on the profitability of investment opportunities available. His model is based upon the following assumption :
(i) Retained earnings is the only source of financing available to the firm.
(ii) The firm’s internal rate of return ‘r’ from the investment opportunities and cost of capital ‘k’ of the firm remains constant.
(iii) The earnings are distributed as dividends or retained for reinvestment.
(iv) The firm has infinite life.
Based on the above assumption, his formula to determine the market price is
P = D+(E-D)r/k /k
Where p = market price of the share.
D = Dividend per share
E = earning per share
R = Internal rate of return from the investment opportunity.
K = market capitalization rate of cost of capital.
They above equation, states that the market price per equity share is the sum of two components:
(i) Present value of an infinite stream of constant dividends i.e., D/k
(ii) The present value of infinite stream of capital gains. (E-D) r/k/k.