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The Gordon Growth Model – also known as the Gordon Dividend Model or
dividend discount model – is a stock valuation method that calculates a
stock’s intrinsic value, regardless of current market conditions. Investors can
then compare companies against other industries using this simplified
model. Major contributors to the model are Myron J. Gordon, Robert F.
Weise, and John Burr Williams.
Three variables are included in the Gordon Growth Model formula: (1) D1
or the expected annual dividend per share for the following year, (2) k or
the required rate of return, and (3) g or the expected dividend growth rate.
With these variables, the value of the stock can be computed as:
Intrinsic Value = D1 / (k – g)
ILLUSTRATION
Company A’s stock is trading at $40 per share. Furthermore, Company A
requires a rate of return of 10%. Currently, Company A pays $2 dividend per
share for the following year and this is expected to increase by 4% annually.
Thus, the value of stock is computed as:
The passive residual policy suggests that a firm should retain its earnings as
long as it has investment opportunities that promise higher rates of return
than the required rate.
For example, assume that a firm’s shareholders could invest their dividends
in stocks of similar risk with an expected rate of return (dividends plus
capital gains) of 18 percent. This 18 percent figure, then, would constitute
the required rate of return on the firm’s retained earnings. As long as the
firm can invest these earnings to earn this required rate or more, it should
not pay dividends (according to the passive residual policy) because such
payments would require either that the firm forgo some acceptable
investment opportunities or raise necessary equity capital in the more
expensive external capital markets.
Interpreted literally, the residual theory implies that dividend payments will
vary from year to year, depending on available investment opportunities.
There is strong evidence, however, that most firms try to maintain a rather
stable dividend payment record over time. Of course, this does not mean
that firms ignore the principles of the residual theory in making their
dividend decisions because dividends can be smoothed out from year to
year in two ways. First, a firm can choose to retain a larger percentage of
earnings during years when funding needs are large. If the firm continues to
grow, it can manage to do this without reducing the cash amount of the
dividend. Second, a firm can borrow the funds it needs, temporarily raise its
debt -to-equity ratio, and avoid a dividend cut in this way.
Because issue costs are lower for large offerings of long -term debt, long
-term debt capital tends to be raised in large, lumpy sums. If many good
investment opportunities are available to a firm during a particular year,
this type of borrowing is preferable to cutting back on dividends.
The firm will need to retain earnings in future years to bring its debt-to-
equity ratio back in line. A firm that has many good investment
opportunities for a number of years may eventually be forced to cut its
dividend and/or sell new equity shares to meet financing requirements and
maintain an optimal capital structure.
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The residual theory also suggests that “growth” firms will normally have
lower dividend payout ratios than firms in mature, low-growth industries.
Companies with low growth rates tend to have rather high payout ratios.
ASSUMPTIONS
Dividends should be paid only when the firm has ready access to new
equity market.
Retained earnings, being the residual earnings of the firm, should
always be paid out to existing stockholders.
Investment policy and dividends policy should always be made
independently
Dividends should be paid out only if the firm does not have enough
acceptable investment projects to utilize all earrings internally.
CASE STUDY
Consider the case of Yellow Duck Distribution Group: Yellow Duck
Distribution Group is expected to generate $240,000,000 in net income
over the next year. Yellow Duck Distribution has forcasted a capital budget
of $85,000,000, and it wishes to maintain its current capital structure of
70% debt and 30% equity.30% equity and 70% debt if the company follows
strict passive residual policy and makes distribution in form of dividends,
what is its expected dividends payout ratio for the year this year? 75.97% O
93.85% O 89.38% 67.01% Most firms have earnings that vary considerably
from year to year and do not grow at a reliably constant pace. Furthermore,
their investment may change often .
3.Increases risk.
This tends to reduce the residual earnings.
WALTER’S MODEL
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If r>K, the firm should retain the earnings because it possesses better
investment opportunities and can gain more than what the
shareholder can by re-investing. The firms with more returns than a
cost are called the “Growth firms” and have a zero payout ratio.
If r<K, the firm should pay all its earnings to the shareholders in the
form of dividends, because they have better investment
opportunities than a firm. Here the payout ratio is 100%.
If r=K, the firm’s dividend policy has no effect on the firm’s value.
Here the firm is indifferent towards how much is to be retained and
how much is to be distributed among the shareholders. The payout
ratio can vary from zero to 100%.
Where,
P = Market price per share;
E = Earnings per share;
k = Cost of capital/capitalization rate.
D = Dividend per share;
r = Internal rate of return;
Illustration 1
The following information relates to alpha limited .shows the effects of
divided policy on market price of the share using Walters model .When
equity capitalization rate , rate=11% ,earnings per share E=sh10 and the
rate of return on investment is assured to be 15% ,11% and 8% ,show the
eefect of dividends policy for the three different levels of returns taking the
dividends payout ratios as 25%.
Solution:
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r>k r=ko
r=15% r=11%
D/P=25% earnings.
=2.5+0.15/0.11(10-2.5) 2.5+0.11/0.11(10-2.5)
0.11 0.11
=115.70 =90.90
r<k
r=8%
2.5+0.08/0.11(10-2.5)
0.11
=72.3
Illustration 2
A company earns sh 5 per share and its capitalized at the rate of 10% while
the rate of return an investment is 12% .According to Walters model , which
should be the price per share at 75% dividends payout .Is this the optimum
dividend payout ratio according to Walters model? Justify.
Solution
At Optimum
r>k
=52.5 =60.0
Constant returns
This model is based on the assumption that returns is constant. In
fact returns decreases as more and more investment is made . this
reflects the assumption that the most profitable investments are
made first and then the poorer investment are made.
DIVIDENDS POLICY
Dividends policy of a company is the strategy followed to decide the
amount of dividends and the timing of payments. A firm’s dividend policy is
influenced by large number of factors.
Since dividends payments represents cash outflow, the more liquid a firm is,
the more able it is to pay dividends unless it has sufficient liquid assets,
primary cash
5.Inflation.
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CONCLUSION
The study investigated the various theories on why dividends are paid in
dividends policy. It mainly focused on the the walter’s model, gordon’s
model and passive residual theory. Though the study concludes that the
dividends policy both relevant and irrelevant Dividend policy is an
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REFERENCES
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4.https://efinancemanagement.com/dividend-decisions/factors-affecting-
dividend-policy
5.https://corporatefinanceinstitute.com/resources/knowledge/valuation/go
rdon-growth model/
6.https//businessjargons.com/walters-model.html
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