WACC, MM Approach, and Walter’s Dividend Model Analysis

Unit III: Cost of Capital and Capital Structure

6. Explain the Concept of WACC with Examples

Meaning

Weighted Average Cost of Capital (WACC) is the average cost of all sources of finance weighted according to their proportion in the capital structure.

Importance

• Used as a discount rate in capital budgeting
• Measures the overall cost of finance
• Helps in capital structure decisions

WACC represents the minimum required return expected by investors and creditors.

7. Describe the Modigliani–Miller (MM) Approach

Meaning

The MM approach states that under perfect market conditions, capital structure does not affect the value of the firm.

Assumptions

• Perfect capital market
• No taxes
• No transaction costs
• Investors behave rationally
• Equal borrowing rates for firms and investors

MM Theory without Taxes

According to MM, firm value is independent of the debt-equity mix. With corporate taxes, debt financing increases firm value because interest is tax deductible.

MM theory provides the foundation for modern capital structure theories.

Unit IV: Dividend Policy and Firm Valuation

8. Dividends Affect Firm Value: Walter’s Model

Dividend policy determines the proportion of profits distributed among shareholders. According to relevance theories, dividends affect the value of the firm.

Walter’s Dividend Model

The model states that dividend policy affects market value depending on the relationship between the internal rate of return (r) and the cost of capital (k).

Pay higher dividends to shareholders.

Conclusion

Walter’s model proves that dividend policy influences the market value of shares.

9. Explain Walter’s Dividend Model with Limitations

Meaning

Walter’s model explains the relationship between dividend policy and the value of the firm.

Advantages

• Explains dividend relevance
• Helps determine optimal payout policy

Limitations

• Assumes no external financing
• Constant return and cost are unrealistic
• Ignores business risk
• Not practical for modern firms

Conclusion

Walter’s model is important in explaining dividend relevance, though it is based on restrictive assumptions.