Question 5 (b)

Gordon's dividend model: assumptions, and whether dividend policy affects value

7 marks

Time to write
About 14 minutes

From an older CBCS paper

Question

Question 5 (b) · 7 marks

Explain the Gordon's model of dividends. What does it assume? Does the value of the firm is affected, as per this model, by the dividend policy?

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

14 minfor 7 marks

Read from the question

  • Explain…What…?Does…?3 questions in all: answer every one.
  • Does the value…?A yes-or-no question: answer it in your first line, then explain why.

What the paper leaves open

"Does the value of the firm is affected" is kept as printed.

Write it in this order

  1. Read; underline the asks; jot your points 1 min
  2. 1 The view: relevance and bird in hand 1½ marks 3 min
  3. 2 Assumptions 2 marks 3 min
  4. 3 Formula and implications 2 marks 3 min
  5. 4 Does dividend policy affect value 1½ marks 3 min
  6. Check: every ask answered, key terms underlined 1 min

Short on time? Trim steps 1–4 evenly rather than skip one: each is capped at its own marks.

Try it first. About 14 minutes for 7 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").

Picture itGordon's dividend model: assumptions, and whether dividend policy affects value

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.

Assumptions:

  1. an all-equity firm, with investment financed only by retained earnings;
  2. the rate of return (r) and the cost of capital (ke) are constant;
  3. a perpetual life;
  4. a constant retention ratio (b), so growth g = br is constant;
  5. 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.

  • r > ke (growth firm): the price rises as the payout falls.
  • r < ke (declining firm): the price rises as the payout rises.
  • r = ke (normal firm): the payout does not affect the price.

Does dividend policy affect the value of the firm? Yes, under Gordon's model dividend policy is relevant. Under certainty its effect depends on r and ke as above: retention raises value for a growth firm and lowers it for a declining firm. Gordon's further argument concerns risk: investors discount distant, uncertain returns at a higher rate, so the discount rate rises with retention. A firm that cuts its payout therefore raises its cost of equity, and even a normal firm (r = ke) can raise its share price by paying more dividends ("a bird in hand is worth two in the bush"). This is the opposite of the MM irrelevance view.

Where the 7 marks sit

#ComponentMarks
1The view: relevance and bird in hand1.5
2Assumptions2
3Formula and implications2
4Does dividend policy affect value1.5
Total7
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