Question 5 (a)
Gordon's model of the relevance of dividends
4 marks
- Time to write
- About 8 minutes
From an older CBCS paper
Question
Question 5 (a) · 4 marksExplain the Gordon's Model of the relevance of dividend.
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- ExplainEach point stated, then explained in a line or two.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 The view relevance; bird in hand 1 mark 2 min
- 2 Assumptions 1 mark 2 min
- 3 Formula and implications 2 marks 3 min
Short on time? Step 3 carries 2 of the 4 marks: guard its minutes.
Try it first. About 8 minutes for 4 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
The view. Myron Gordon holds that dividend policy affects the value of the share: investors are risk-averse and value current dividends more highly than uncertain future gains, so they discount a firm's earnings at a lower rate when more is paid out ("a bird in hand").
1Sunita holds this year's dividend—money in her hand today.
Current dividendsInvestors put a premium on certain returns.
2Verma ji's payout sits inside a half-built project, and he worries.
Retained earningsUncertain future gains.
3At the counter, savers crowd the company that pays now over the one that promises later.
Bird in handInvestors are risk averse and value current dividends more than uncertain future gains.
- an all-equity firm, with investment financed only by retained earnings;
- the rate of return (r) and the cost of capital (ke) are constant;
- a perpetual life;
- a constant retention ratio (b), so growth g = br is constant;
- ke > br.
The formula. P = E(1 − b) ÷ (ke − br), where P is the share price, E the earnings per share, b the retention ratio, r the rate of return on investment and ke the cost of equity.
Implications. Gordon's conclusion: the optimum payout is zero for a growth firm, 100% for a declining firm, and there is no optimum when r = ke.
- r > ke (growth firm): the price rises as the payout falls.
- r < ke (declining firm): the price rises as the payout rises, which is why the optimum payout is 100% (the source's prose at this point pairs r < ke with a falling price, but its formula and its 100% optimum show a rising one).
- r = ke (normal firm): the payout does not affect the price.
Where the 4 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | The view (relevance; bird in hand) | 1 |
| 2 | Assumptions | 1 |
| 3 | Formula and implications | 2 |
| Total | 4 |
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