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Gordon Growth Model

Gordon Growth Model

The theory  which contends that dividends are relevant is the Gordons’ model. This model explicitly relates the market value of the firm to dividend policy. In this model, the current ex-dividend at the amount which shareholders expected date of return exceeds the constant growth rate of dividends. It is based on the following assumptions:

• The firm is an all equity firm, and it has no debt.

• No external financing is used and investment programmes are financed exclusively by retained earnings.

• The internal rate of return, r, of the firm is constant.

• The appropriate discount rate, ke, for the firm remains constant.

• The firm has perpetual life.

• The retention ratio, b, once decided upon, is constant. Thus, the growth rate, g = br, is also constant.

• The discount rate is greater than the growth rate, ke> br.

Gordon Growth Model

Myron Gordon argues that what is available at present is preferable to what may be available in the future. As investors are rational, they want to avoid risk and uncertainty. They would prefer to pay a higher price for shares on which current dividends are paid. Conversely, they would discount the value of shares of a firm which postpones dividends. The discount rate would vary with the retention rate.

The formula given by Gordon shows that when the rate of return is greater than the discount rate, the price per share increases as the dividend ratio decreases and if the return is less than discount rate it is vice-versa. The price per share remains unchanged where the rate of return and discount rate are equal.

Gordon Growth Model

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Gordon Growth Model

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