GORDON’S GORDON’S GROWTH MODELGROWTH MODEL

MYRON.J.GORDONMYRON.J.GORDON

WHAT IS DIVIDEND ?WHAT IS DIVIDEND ?

Payments made to stockholders from Payments made to stockholders from the firm’s earnings, whether those the firm’s earnings, whether those earnings were generated in the earnings were generated in the current period or in previous periods. current period or in previous periods.

Portion of profit ( after tax ) Portion of profit ( after tax ) distributed among owners/ distributed among owners/ shareholders of the firm.shareholders of the firm.

May be distributed in form of cash, May be distributed in form of cash, scrip, or bonus shares. scrip, or bonus shares.

TYPES OF DIVIDEND TYPES OF DIVIDEND THEORIESTHEORIES

EXPLANATION:-EXPLANATION:-

DIVIDEND THEORIES

RELEVANCE THEORY

IRRELEVANCE THEORY

WALTER’SMODEL

GORDON’SMODEL

MM MODEL

RESIDUALMODEL

RELEVANCE THEORYRELEVANCE THEORY

Dividend policy is very essential for any Dividend policy is very essential for any business firm as it affects the overall value business firm as it affects the overall value of the firm.of the firm.

Dividend policy is relevant & dividend Dividend policy is relevant & dividend decision form a very integral part of the decision form a very integral part of the investment & financing decision of the firm. investment & financing decision of the firm.

Shareholders prefer current dividends & Shareholders prefer current dividends & hence there is a direct relationships hence there is a direct relationships between the dividend policy & the market between the dividend policy & the market value of the firm. value of the firm.

GORDON’S DIVIDEND GORDON’S DIVIDEND MODELMODEL

Dividend policy is relevant to the value of Dividend policy is relevant to the value of the company. the company.

Also known as the ‘bird in hand’ argumentAlso known as the ‘bird in hand’ argument Dividend policy is relevant as the investors Dividend policy is relevant as the investors

prefer current dividends as against the prefer current dividends as against the future uncertain capital gains.future uncertain capital gains.

Investors discount the firm’s earnings at Investors discount the firm’s earnings at lower rate when they are certain about lower rate when they are certain about returns, placing a higher value for the returns, placing a higher value for the share and that of the firm. share and that of the firm.

GORDON’S MODEL -- GORDON’S MODEL -- assumptionsassumptions

No external financing is available.No external financing is available. The firm has infinite life.The firm has infinite life. Investors are basically risk-averse.Investors are basically risk-averse. The growth rate of firm ‘g’ is the product The growth rate of firm ‘g’ is the product

of its retention ratio ‘b’ and its rate of of its retention ratio ‘b’ and its rate of return ‘r’, i.e., g = br. return ‘r’, i.e., g = br.

The cost of capital is constant and also The cost of capital is constant and also more than growth rate, i.e., k > gmore than growth rate, i.e., k > g

Corporate tax does not exist.Corporate tax does not exist.

Gordon’s Model EquationGordon’s Model Equation

P = EPS ( 1 – b )P = EPS ( 1 – b ) k- br k- br

P = Market price per share P = Market price per share b = Retention ratiob = Retention ratio r = Rate of Returnr = Rate of Return br = Growth Ratebr = Growth Rate Ke = Equity Capitalization Rate.Ke = Equity Capitalization Rate.

GORDON’S MODEL - GORDON’S MODEL - DecisionsDecisions

Where,( r =rate of return & k= cost of Where,( r =rate of return & k= cost of cap.)cap.)

If r > k >g :- company should If r > k >g :- company should distribute less dividend and retain distribute less dividend and retain high profit high profit

If r < k :- company should distribute If r < k :- company should distribute more profits as dividend more profits as dividend

If r = k :- payout ratio is not affected If r = k :- payout ratio is not affected by retention ratio. by retention ratio.

ILLUSTRATIONILLUSTRATION

OPTIONSOPTIONS D/P RATIOD/P RATIO

(1-b)(1-b)RETENTIORETENTIO-N RATIO-N RATIO

(b)(b)

Ke(%)Ke(%)

1.1. 1010 9090 2020

2.2. 2020 8080 1919

3.3. 3030 7070 1818

WHERE,E=Rs. 20 & r= 12%

SOLUTIONSOLUTION

OPTION-1.OPTION-1.

P = E ( 1 – b )P = E ( 1 – b )

k- br k- br

=20(1-.90)/=20(1-.90)/0.20-0.1080.20-0.108

=2/0.092=2/0.092

=21.74=21.74

OPTION-2.OPTION-2.

P = E ( 1 – b )P = E ( 1 – b )

k- br k- br

=20(1-.80)/=20(1-.80)/0.19-0.00960.19-0.0096

=4/0.094=4/0.094

=42.55=42.55

OPTION-3.OPTION-3.

P = E ( 1 – b )P = E ( 1 – b )

k- br k- br

=20(1-.70)/=20(1-.70)/0.18-0.0840.18-0.084

=6/0.096=6/0.096

=62.5=62.5

WHERE,E=Rs. 20 & r= 12%

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