Home | ARTS | Financial Management | Gordon’s model and its relevance - 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
Last 30 days 1183 views