TOPIC: GORDONS MODEL OF DIVIDEND THEORIES

Submitted By
RASHMI RANJAN SAHOO ROLL NO-13201FM112033 2ND Semester MBA

Submitted To
DR. ARTTA BANDHU JENA LECTURE

P.G. DEPARTMENT OF BUSINESS MANAGEMENT FM UNIVERSITY, BALASORE

INTRODUCTION
Dividend is the distribution of value to shareholders. Dividend Policies involve the decisions to retain earnings for capital investment and other purposes; or to distribute earnings in the form of dividend among shareholders; or to retain some earning and to distribute remaining earnings to shareholders . According to Prof. Gordon, Dividend Policy almost always affects the value of the firm. He Showed how dividend policy can be used to maximize the wealth of the shareholders. The main proposition of the model is that the value of a share reflects the value of the future dividends accruing to that share. Hence, the dividend payment and its growth are relevant in valuation of shares. The model holds that the shares market price is equal to the sum of shares discounted future dividend payment.

Gordon model:
Gordons model contends that dividends are relevant. This model which opines that dividend policy of a firm affects its value, is based on the following assumption. The firm is an all equity firm and has no debt External financing is not used in the firm. Retained earnings represent the only source of financing. The internal rate of return is the firms cost of capital k. It remains constant and is taken as the appropriate discount rate. Future annual growth rate dividend is expected to be constant.

 Growth rate of the firm is the product of retention ratio and its rate of return. Cost of Capital is always greater than the growth rate. The company has perpetual life and the stream of earnings are perpetual. Corporate taxes does not exist. The retention ratio b once decided upon, remain constant. Therefore, the growth rate g=br, is also constant forever. Arguments: It can be seen from the assumptions of Gordons model that they are similar to those of Walter model. As a result, Gordons model, like Walters model, contends that dividend policy of the firm is relevant and that investors put a positive premium on current incomes/dividends. The crux of Gordons arguments is a two-fold assumption: (i) investors are risk averse and (ii) they put a premium on a certain return and discount/penalise uncertain returns. As investors are rational, they want to avoid risk. The term risk refers to the possibility of not getting a return on the investment. The payment of current dividends ipso facto completely removes any chance of risk. If, however, the firm retains the earnings (i.e. current dividends are withheld), the investors can expect to get a dividend in future. The future dividend is uncertain, both with respect to the amount as well as the timing. The rational investors can reasonably be expected to prefer current dividend. In other words, they would discount future dividends, that is, they would place less importance on it as compared to current dividend. The retained earnings are evaluated by the investors as a risky promise. In case the earnings are retained, therefore, the market price of the shares would be adversely affected.

The above argument underlying Gordons model of dividend relevance is also described as a bird-in-the-band argument. That a bird in hand is better than two in bush is based on the logic that what is available at present is preferable to what may be available in future. Basing his model on this argument, Gordon argues that the future is uncertain and the more distant the future is, the more uncertain it is likely to be. If, therefore, current dividends are withheld to retain profits, whether the investors would at all receive them later is uncertain. Investors would naturally like to avoid uncertainty. In fact, they would be inclined 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 rates would vary as shown in below figure, with the retention rate or level of retained earnings. The term retention ratio means the percentage of earnings retained. It is the inverse of D/P ratio. The omission of dividends, or payment of low dividends, would lower the value of the shares.

Dividend Capitalisation Model: According to Gordon, the market value of a share is equal to the present value of a share is equal to the present value of future streams of dividends. A simplified version of Gordons model can be symbolically expressed as

Where p= price of share E= Earnings per share b= Retention ratio or percentage of earnings retained 1 b= D/P ratio i.e. percentage of earnings distributed as dividends ke= Capitalisation rate or cost of capital br=g= growth rate= Rate of return on investment of an all-equity firm