M.

Thinesh kumar
M.Phil Scholar
KMCPGS, Lawspet
Puducherry
Gordon’s model
 Gordon’s model and its relevance
 Gordon, model explicitly relates the market value of the firm
to its dividend policy. It is based on the following hypotheses
Hypotheses
 An all equity firm
 A firm is an all equity firm and it has no debt.
 No external financing
 A firm has no external finance available for it. Therefore
retained earnings would be used to fund or finance any
expansion. Gordon’s model also supports dividend and
investment policies.
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 Constant return
 The firm’s internal rate of return, r, is constant.
 Constant cost of capital
 The discount rate, k, is constant as in Walter’s model.
Gordon’s model also overlooks and ignores the effect of
a change in the firm’s risk-class and its effect on the
discount rate, k.
 Permanent earnings
 It is assumed the firm and its stream of earnings are
perpetual
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 No taxes
 It is also assumed that the firm does not pay tax on the
premise that corporate taxes do not exist
 Constant retention
 The retention ratio (b) once decided is taken as
constant. Thus, the growth rate is constant forever as the
internal rate of return is also assumed to be constant
 Cost of capital greater than growth rate
 The discount rate, k, is greater than the above growth
rate (g = br).
Valuation Gordon’s model
 Based on the above assumptions, Gordon has put
forward the following formula:

 P0 = EPS1 (1 – b) / (k – b)
Where.,
 P0 = market price per share
 EPS1 = expected earnings per share
 b = retention ratio
 r = firm’s internal profitability
 k= firm’s cost of capital or capitalisation rate
Example
 The following information is available for ABC Company.
Earnings par share : Rs.5.00 Rate of return required by
shareholders :16percent. Assuming that the Gorden
valuation model holds, what rate of return should be
earned on investments to ensure that the market price is
Rs.50 when the dividend payout is 40 percent?
Solution:
According to the Gordon model P0 = EPS1 (1 – b) / (k – b)
 Substituting in this equation,
Thank
the various valuesYou
given, we get
Jai– Hind
50 = 5.0(1- 0.06) / (0.16 0.6r)
 Solving this for r, we get
R = 0.20 = 20 percent
 Hence, ABC Company must earn a rate of return of 20
percent on its investments.