Question 4 (a)
Short notes: stability of dividend; Gordon's model
6 marks
- Time to write
- About 12 minutes
Question
Question 4 (a) · 6 marksWrite a short note on the following:-
Stability of dividend
Gordon's Model
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
- (i)–(ii)2 items, each marked on its own: give each its share.
- short noteA note opens with the meaning, then two or three key points. No long introduction.
Write it in this order
The parts stand alone: start with the one you are surest of.
- Read; underline the asks; jot your points 1 min
- 1 Stability of dividend 3 marks 5 min
- 2 Gordon's model: formula, assumptions and implications 3 marks 5 min
- Check: every ask answered, key terms underlined 1 min
Short on time? A few lines on every part beat a full answer to one: each part is capped at its own marks.
Try it first. About 12 minutes for 6 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.
Stability of dividend means paying a regular, steady dividend rather than one that swings with each year's earnings. It may take the form of a constant amount per share, maintained over a long period and supported if necessary by a dividend equalisation reserve, or a constant payout ratio, a fixed percentage of each year's earnings.
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.
Firms prefer stability because investors who depend on dividend income (individuals and institutions) value a regular dividend; a steady record builds confidence and supports the share price; and it helps the firm raise funds when needed. A firm usually raises its dividend only when it expects the higher earnings to last.
Myron Gordon holds that dividend policy is relevant to the value of the share. The share's price is the present value of an infinite stream of dividends growing at a constant rate:
P0 = E(1 − b) ÷ (ke − br), where b is the retention ratio and br = g, the growth rate.
Assumptions: an all-equity firm financing investment only from retained earnings; constant r and ke; a perpetual life; a constant retention ratio, so constant growth; and ke > br.
Implications. If r > ke, retaining more raises the price; if r < ke, paying more raises it; if r = ke, the basic formula gives the same price at any payout. In his revised ("bird-in-hand") argument, investors are risk averse and value certain current dividends more than uncertain future gains, so a higher payout lowers the discount rate and raises the price.
Where the 6 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Stability of dividend | 3 |
| 2 | Gordon's model: formula, assumptions and implications | 3 |
| Total | 6 |
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