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What are the assumptions of Gordon's Dividend Model?
Gordon’s dividend model is a progression of Walter’s model as it adds some more restrictions to the theory. Gordon’s model however rests on the same assumptions Walter’s theory proposes in the very first place.
Assumptions of Gordon's Theory
The assumptions of Gordon’s theory are discussed below.
Gordon considers the firms to be of 100% equity. Moreover, it should not have any debt financing for calculating the dividends in practice.
No External Financing
To be considered under Gordon’s model, a company must have good financial health. In other words, the company must be able to finance all its projects by its own internal funds. No external funding, whether debt or equity, must not be utilized to finance the projects of a business under Gordon’s model.
Constant Internal Rate of Return
The companies under Gordon’s model have constant internal rate of return. That is, a firm that is considered under Gordon’s dividend policy has no changes in its internal rate of earnings. This is assumed due to the fact that the firm does not depend on any external funding for its projects. When a company has constant return, it can rely upon its own earnings rather than borrowing funds externally.
Constant Cost of Capital
The cost of capital must remain the same of a firm if it has to be evaluated under Gordon’s dividend theory model. Therefore, Gordon’s model ignores the changes in the risk class of the assets of a firm and the effect of these classes are also ignored by the theory. Although, constant cost of capital is nearly impossible to theorize, Gordon’s model assumes it is applicable in calculating the valuation of an ideal model for risk averse businesses.
The share considered under Gordon’s model is one that offers dividends to the shareholders for an infinite tenure. The tenure of a shareholder’s earnings must be perpetual to be considered under Gordon’s model, which limits the number of shares to be considered under Gordon’s model for evaluation of the dividend policy of the firm regarding the valuation of the company.
Gordon's model assumes that the firms under it do not have to pay any corporate taxes. That is, the company does not need any tax shield to defer its payment terms which also affects its outgoing cash flow.
Gordon’s model considers firms to have a constant retention policy. Once the retention ratio is fixed, it should remain constant for the entirety of the project.
Cost of Capital Larger than Growth Rate
The cost of capital considered for a company under Gordon’s dividend policy must have a cost of capital greater than the growth rate of the firm.
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