Dividend Theories - Relevance Concept - Gordon's Model.Solved Problems.
Myron J. Gordon has also put forth a model arguing for the relevance of the Dividend decision to the valuation of the firm.
The model is founded on the following assumptions.
The firm is an equity firm.
No external financing is used and investment programs are financed exclusively by retained earnings.
Corporate taxes do not exist.
The firm's life and earnings are perpetual.
The cost of capital is greater than the growth rate.
Gordon views:
- Investors always prefer Dividend as current Income
- Current Dividends removes the possibility of Risk
- Investors emphasis on current Dividend
- When a firm retains its earnings, the Share Price will receive a setback
- Even when r = k Investors prefer the current Dividend ( It is a contrast with Walter’s Model)
Gordon's Formula
Market Value per share(P) = D/ k - g
Implications
- The optimal payout ratio for a growth firm is Nil
- The payout ratio for a normal firm is irrelevant
- The optimal payout ratio for a declining firm is 100%
Criticisms
- Assumption of 100% equity funding defeats the objective of maximization of wealth, by leveraging against a lower cost of debt capital
- Constant rate of return and current opportunity costs are not in tune with realities.
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