Explain the ‘Gordon’s model’ related to ‘dividend ‘relevance school’.
Explain MM theory related to Dividend irrelevance
I hope you people are clear with the Walter’s model of dividend policy, Lets come to yet another popular model explicitly relating the market value of the firm to dividend policy developed by Myron Gordon.
Gordon proposed a model of stock valuation using the dividend capitalisation approach. His model is based on the following assumptions:
1. All-equity firm: The firm is an all-equity firm, and it has no debt
2. No external financing: Retained earnings would be used to finance any expansion.
3. Constant return: The internal rate of return, r, of the firm’s investment is constant.
4. Constant cost of capital: The appropriate discount rate k for the firm remains
constant and is greater than the growth rate.
5. No taxes: Corporate taxes do not exist.
6. Constant retention: The retention ratio, b, once decided upon, is constant.
Valuation Formula: Based on the above assumptions, Gordon put forward the following formula:
P0 = EPS1 (1-b)
P0 = price per share at the end of year 0
EPS1= earnings per share at the end of year 1
(1-b) = fraction of earnings the firm distributes by way of earnings
b= fraction of earnings the firms ploughs back
k= rate of return required by the shareholders
r = rate of return earned on investments made by the firm
br = growth rate of earnings and dividends
Let’s apply the Gordon’s formula to a practical illustration to be clearer. We will again take an example of three firms; growth, normal and the declining one. The financial highlights of all these firms is given as follows:
(r = k)
• The marker value of the share, P0, increases with the payout ratio, (1-b), for declining firms. i.e. when r < k.
• The market value of the share is not affected by dividend policy when r = k
You must have noticed that Gordon’s model’s...