Management (1. Y.B.M.S.

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Strategic Financial Page 1 of 4

18

11.1 ASSUMPTIONS
is based on the following
assumption.
using dividend capitalization
Gordon growth valuation model
(a) The firm is an all-equity firm and has no debt. source of
firm. Retained earnings represent the only
(b) External financing is not used in the
appropriate discount rate. as
rate of return is the firm's cost of capital
K'. It remains constant and is taken l
(C) The internal
appropriate discount rate.
(d) Future annual growth rate dividend is expected to be constant.
(e) Growth rate of thefirm is the product
of
retention ratio and its rate of return.
(t) Cost of capital is always greater than the growth rate.
(8) The company has perpetual life and the stream ofearnings are perpetual.
(h) Corporate taxes does not exist.
() The retention ratio 'b' once decided upon, remains constant. Therefore, the growth rate g= br, i
also con stant forever.
In valuation of share under Gordon growth model, the following
formula is used:
P, =
D, (1 + g) D,
Ke - g
K -g
Where,
P Current ex-dividend market price
of share.
D
Current year 's dividend.
D, Expected dividend.
Ke = Cost of equity capital i.e.
expected rate of return on
= Expected equity capital.
future growth rate of dividends.
The shareholders' required
rate of return
model. The model requires (K)can also be calculated by using
the estimation of future growth the capital asset pricing
using dividend capitalization can of dividends. The Gordon
also be presented as follows : Growth Model
=
E (1 - b)
P
K, – br
Where,
= Current
P. ex-dividend market
E price of equity share
Expected earnings per
share
b = Retention
ratio
(1-b) = Dividend payout
ratio
K. = Cost
of capital or Capitalization
br = rate
g=Growth rate of
earnings and dividends.
The Gordon growth model assumes
investment in projects. If these that a constant
rate. The Gordon assumptions, retention ratio
earnings andand constant return on new
growth model hold, both
usedto show
a
dividend paying capacity. that the value dividends
the discount rate, the priceThe
per
implications of
the model is ofa company grow at the samt
share that when ultimately
than discount rate it is vice versa. increases as the rate depends on its
and discount rate are The the dividendratio of return
is greater than
equal. In fact:someprice per share decreases
difficulties. The above remains and if
theory of :share companies, although unchanged where the return is
less
day presumably they will start valuation earning profits, the rate of returt
paying dividends. can still be elect
obtain any returns from company. applied to them by financial
the This
policies of the company, The reason is the only basisthese companies, Since one
At some time in
the rapid growth the price of on which
altersinvestor
the future, large dividends shares shareholders cal
determine the company's can expectations rises is that
share price. be paid. So aboutthe with retentiot
once future size ofdividends
again it can
be said ihat
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Dividend Decision and XBRL Page

19 2 of 4

11.2 CRITICISM
The Gordon Growth Model is criticized for the following reasons :
(a) In real world, the constant dividend growth and earnings growth is a fallacy.
(b) The model implies that if Da' is zero, the value of shareis nil.
(c) The capital gains are ignored by the model.
(d) The false assumption is that investors will buy and hold the shares for an infinite period of time.
(e) The model ignores the allowance for corporate and personal taxation.
(D The diminishing marginal efficiency of investment is ignored.
(g) The efect of change in the firm's risk-class and its effect on firm's cost of capital is ignored.

11.3 ILLUSTRATIONS
:

Illustration 2
Roval Products Ltd. is an established company having its shares quoted in the major stock exchanges.
Its share current market price after dividend distributed at the rate of 21% p.a. having a paid up
share capitalof T 50 lakhs of 10 each. Annual growth rate in dividend expected is 3%. The expected
kate of return on its equity capital is 16%.
Calculate the value of Royal Products Ltd., share based on dividend g rowth model.
:
Solution
x
Dividend Distributed during the year 21/100 =10,50,000
=
50,00,000
D,(1 + 9) 710,50,000 (1 + 0.03) =83,19,231
K-9 0.16 0.03
= 16.64
Value per share=83,19.231/5,00,000 equity shares
Illustration 3:
M Ltd. has total investment of 15,00,000 assets and 1,50,000 outstanding Equity shares of 10
rate 10%, determine
each. Itearns a 15% rate of interest on investments. the appropriate discOunt if is company
If

the price of the share using Gordon Model. What shall happen the
to price, the has a
payout of 60% of 40%.
:
Solution
b= Retention Ratio = 0.50, 0.40, 0.60
K= Discount Rate = 0.10
r= Rate of Return =0.15
EPS 0.15 x 10=1.50
=

(EPS) (1 - b)
P= -
Ke br
is
At a payment of 50% the price of the share
1.50 (1 - 0.50)
P= x
0.15)
0.10- (0.50
0.75
0.025
=30 is
payment of 60% the price of the share
Ata

1.50(1 - 0.40)
P=
0.10 - (0.40 x 0.15)
0.9
0.04
= 22.50
When the payment is 40% the price of the share is
1.50 (1 - 0.60)
P=
0.10 - (0.60 × 0.15)
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Strategic
20

0.6
0.01
=R60
of return is 12%, ar
Illustration 4: 11%, internal rate
of ABC Ltd.is Approach' method if divide-
The rate of retum expected byinvestors per share by'Gordon's
price
earning per share is 15. Calculate the
payout ratio is 20% and 40%.
Solution:
EPS (1 - b)
P= -
Ke br
where EPS=15
or 0.60
b=0.08
r=0.12
K = 0.11

dividend payout is 20% price of share

If

15(1 0.80)
P=
0.11 - (0.80 x 0.12)
3
0.11 - 0.096
3
0.014
=214.29
If dividend payout is 40% price of
share
15(1 - 0.60)
P=
0.11 - (0.12 x 0.60)
6
0.038
=157.89
lllustration 5:
Max Ltd. provides you
with following information
Growth rate =
2%
Dividend payout =
40%
Face value of shares
Return on Equity =10
Capital = 15%
Find out price of
share as per Gordon's
Solution: Model.
Dividend per
share = Dividend
= 40% x
payout x Face
10 value of shares
..
D= 4 =4
K
=0.15
g=0.02
D(1 + g)
P=
Ke
4(1 + 0.02)
0.15 0.02
4.08
0.13
=31.38
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21
Dividend Decision and XBRL
Illustration 6:
per share last year. The estimated growth of dividend fromif the
Zee Ltd. has paid dividend of 10 of the equity share the
company is estimated to be 15% p.a. Determine the estimated market price
:

growth rate of dividend

(i) Increase by 10%
(iü) Decrease by 5%.

The required rate of return on equity is 20%.

Solution :
(a) As per Present Market Price
D= 10
g=0.15
K = 0.20
D(1 + g)
P= -
Ke 9
10(1 + 0.15)
0.20 - 0.15
11.5
0.05
=7230 =
(b) Growth rate of dividend increase by 10% 15%
x 10% = 16.5%
.. g= 0.165
D= 10
K, = 0.20
D(1 + g)
P =
Ke
10(1 + 0.165)
0.20 0.165
11.65
0.035
=332.85
(c) Growth rate decrease by 5%
= 15% x 5% = 0.75
= 15 - 0.75 = 14.25% = 0.1425
D= 10
K
=0.20
D(1 + g)
P=
Ke -9
10(1 + 0.1425)
0.20 0.1425
11.425
0.0575
=198.69

12. WALTER'S VALUATION MODEL

Prof. JamesE. Walter argued that in the long-run the share prices reflect only the present value of
on future dividends.
expected dividends. Retentions influence stock price only through their efect
Walter has formulated this and used the dividend to optimize the wealth of an equity shareholder.
His formula in determination of expected market price of a share is given below :

D+
Re
P=
Re