Myron Gorden used the dividend capitalization approach to study the effect of the firm's dividend policy on the stock price. The model was however, based on the following assumption:
Assumptions:
I. The firm will be an all-equity firm with the new investment proposals being financed solely by the retained earnings.
II. Return on investment ( r ) and the cost of equity capital ( Ke ) remains constant.
III. Firm has an infinite life.
IV. The retention ratio remains constant and hence the growth rate also is constant ( g = br ).
V. K > br i.e. cost of equity capital is greater than the growth rate.
Golden's model, which has assumptions same as the walter's model is also similar to the walter's model on dividend policy. Gordon's model assumes that the investors are rationa and risk-averse. They prefer certain returns to uncertain returns and thus put a premium to the certain returns and discount the uncertain return. Thus investors whould prefer current dividends and avoid risk. Retained earnings involve risk and so the investor discounts the future dividends. This risk will also affect the stock value of the firm.
Gordon's dividend capitalization model gave the value of the value of the stock as follows:
E( 1 - b )
P = ------------
ke - br
P = Share price
E = Earning per share
b = Retention ratio
(1-b) = Dividend payout ratio
ke = Cost of equity capital ( or cost capital of firm )
br = Growth rate (g) in the rate of return on investment.
Criticisms : It suffers from the same criticisms as the wolter's model
Assumptions:
I. The firm will be an all-equity firm with the new investment proposals being financed solely by the retained earnings.
II. Return on investment ( r ) and the cost of equity capital ( Ke ) remains constant.
III. Firm has an infinite life.
IV. The retention ratio remains constant and hence the growth rate also is constant ( g = br ).
V. K > br i.e. cost of equity capital is greater than the growth rate.
Golden's model, which has assumptions same as the walter's model is also similar to the walter's model on dividend policy. Gordon's model assumes that the investors are rationa and risk-averse. They prefer certain returns to uncertain returns and thus put a premium to the certain returns and discount the uncertain return. Thus investors whould prefer current dividends and avoid risk. Retained earnings involve risk and so the investor discounts the future dividends. This risk will also affect the stock value of the firm.
Gordon's dividend capitalization model gave the value of the value of the stock as follows:
E( 1 - b )
P = ------------
ke - br
P = Share price
E = Earning per share
b = Retention ratio
(1-b) = Dividend payout ratio
ke = Cost of equity capital ( or cost capital of firm )
br = Growth rate (g) in the rate of return on investment.
Criticisms : It suffers from the same criticisms as the wolter's model
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