Question 4 (a)

Gordon's model of the dividend decision

6 marks

Time to write
About 12 minutes
Topic
Dividend theories and dividend policy

Question

Question 4 (a) · 6 marks

Explain Gordon's Model of the Dividend decision. What assumptions does it make? As per this model, is the value of firm affected by its 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

12 minfor 6 marks

Read from the question

  • Explain…What…?Is…?3 asks, each with its own marks below. Answer all 3.

Write it in this order

  1. Read; underline the asks; jot your points 1 min
  2. 1 Model and formula 2 marks 3 min
  3. 2 Assumptions 2 marks 3 min
  4. 3 Effect of dividend policy on value 2 marks 3 min
  5. Check: every ask answered, key terms underlined 2 min

Short on time? Trim steps 1–3 evenly rather than skip one: each 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.

The model. Myron Gordon's model holds that dividend policy is relevant: it affects the market value of the share. The share's price is the present value of an infinite stream of dividends growing at a constant rate:

Picture itGordon's model of the dividend decision

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.

P0 = E(1 − b) ÷ (ke − br), where E = earnings per share, b = retention ratio, (1 − b) = payout ratio, r = return on investment, ke = cost of equity, and br = g, the growth rate.

Assumptions

  1. The firm is all-equity; investment is financed only from retained earnings, with no external financing.
  2. The return on investment (r) and the cost of equity (ke) are constant.
  3. The firm has a perpetual life.
  4. The retention ratio, once decided, is constant, so growth g = br is constant.
  5. The cost of equity exceeds the growth rate: ke > br.

Is the value of the firm affected by dividend policy? Yes.

  • If r > ke, retaining more raises the price, so a low payout maximises value.
  • If r < ke, paying out more raises the price.
  • If r = ke, the basic model gives the same price at any payout; but in Gordon's revised ("bird-in-hand") argument, investors are risk averse and value a certain current dividend more than an uncertain future gain, so they discount the earnings of a firm that retains more at a higher rate. A higher payout then raises the share price, and dividend policy remains relevant.

Where the 6 marks sit

#ComponentMarks
1Model and formula2
2Assumptions2
3Effect of dividend policy on value2
Total6
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