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