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Financial Management - DIVIDEND POLICIES

Gordon’s model and its relevance - DIVIDEND POLICIES

   Posted On :  20.06.2018 06:10 am

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’s model and its relevance
 
Gordon, Myron, J’s model explicitly relates the market value of the firm to its dividend policy. It is based on the following hypotheses
 
An all equity firm
 
A firm is an all equity firm and it has no debt.
 
No external financing
 
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.
 
Constant return
 
The firm’s internal rate of return, r, is constant.
 
Constant cost of capital
 
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.
 
Permanent earnings
 
It is assumed the firm and its stream of earnings are perpetual
 
No taxes
 
It is also assumed that the firm does not pay tax on the premise that corporate taxes do not exist
 
Constant retention
 
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
 
Cost of capital greater than growth rate
 
The discount rate, k, is greater than the above growth rate (g = br).
 
Valuation Formula
 
Based on the above assumptions, Gordon has put forward the following formula:

P0 = EPS1 (1 – b) / (k – b)
 
P0 = market price per share
 
EPS1 = expected earnings per share
 
b = retention ratio
 
r = firm’s internal profitability
 
k= firm’s cost of capital or capitalisation rate
 
Example
 
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?
 
Solution:
 
According to the Gordon model P0 = EPS1 (1 – b) / (k – b)
 
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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