Model Answer
0 min readIntroduction
Dividend policy, a crucial aspect of corporate finance, determines how a company distributes its profits to shareholders. Two prominent approaches to understanding this policy are those proposed by James Walter (1956) and Myron J. Lintner (1956). Walter’s model focuses on the relationship between a firm’s internal rate of return and its cost of capital, while Lintner’s model emphasizes investor preferences and the smoothing of dividend payouts. Both models, though differing in their approach, aim to explain how dividend decisions impact firm value.
Walter’s Approach
Walter’s model posits that dividend policy is relevant only when a firm’s internal rate of return (r) differs from its cost of equity (k). If r > k, the firm should retain earnings and reinvest, maximizing shareholder wealth. Conversely, if r < k, dividends should be paid out as investors can earn a higher return elsewhere. This model assumes a constant growth rate and no external financing.
Lintner’s Approach
Lintner’s ‘dividend smoothing’ model suggests that firms prefer a stable dividend policy to avoid signaling effects. He proposed a partial adjustment model where firms adjust dividends towards a target payout ratio based on long-run sustainable earnings. This target is influenced by investor preferences for current income versus capital gains. Lintner’s model acknowledges the information content of dividends and the importance of investor psychology.
Comparative Analysis
| Feature | Walter’s Model | Lintner’s Model |
|---|---|---|
| Key Focus | Firm’s r & k | Investor Preferences & Smoothing |
| Dividend Relevance | Relevant when r ≠ k | Always relevant (signaling effect) |
| Assumptions | Constant growth, no external financing | Rational investors, information asymmetry |
While Walter’s model provides a theoretical framework based on financial metrics, Lintner’s model offers a more realistic view incorporating behavioral aspects. Both models have limitations; Walter’s assumes unrealistic conditions, and Lintner’s relies on assumptions about investor rationality.
Conclusion
In conclusion, Walter and Lintner offered contrasting yet complementary perspectives on dividend policy. Walter’s model highlights the financial implications of reinvestment versus payout, while Lintner’s emphasizes the psychological and signaling aspects. Modern dividend policy often incorporates elements of both approaches, recognizing the interplay between financial performance, investor expectations, and the need for stable and informative dividend payouts.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.