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Gordon, Myron, J’s model explicitly relates the market value of the firm to its dividend policy. It is based on the following hypotheses

Gordon, Myron, J’s model explicitly relates the market value of the firm to its dividend policy. It is based on the following hypotheses

A firm is an all equity firm and it has no debt.

A firm has no external finance available for it. Therefore retained earnings would be used to fund or finance any expansion. Gordon’s model also supports dividend and investment policies.

The firm’s internal rate of return, r, is constant.

The discount rate, k, is constant as in Walter’s model. Gordon’s model also overlooks and ignores the effect of a change in the firm’s risk-class and its effect on the discount rate, k.

It is assumed the firm and its stream of earnings are perpetual

It is also assumed that the firm does not pay tax on the premise that corporate taxes do not exist

The retention ratio (b) once decided is taken as constant. Thus, the growth rate is constant forever as the internal rate of return is also assumed to be constant

The discount rate, k, is greater than the above growth rate (g = br).

Based on the above assumptions, Gordon has put forward the following formula:

P

EPS

b = retention ratio

r = firm’s internal profitability

The following information is available for ABC Company. Earnings par share : Rs.5.00 Rate of return required by shareholders : 16 percent. Assuming that the Gorden valuation model holds, what rate of return should be earned on investments to ensure that the market price is Rs.50 when the dividend payout is 40 percent?

According to the Gordon model P

Substituting in this equation,

the various values given, we get 50 = 5.0(1- 0.06) / (0.16 – 0.6r)

Solving this for r, we get R = 0.20

= 20 percent

Hence, ABC Company must earn a rate of return of 20 percent on its investments.

Tags : Financial Management - DIVIDEND POLICIES

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