What are the limitations of Gordon's Growth Model?

Banking & FinanceFinance ManagementGrowth & Empowerment

Gordon’s Growth Model, also known as the Dividend Discount Model, is a popular method to consider the value of a firm via the dividend valuation of a firm. It shows the strength of an investment project to run without any external support.

As no external funds are used and the projects are funded 100% on their own, Gordon’s model is only about an imaginative model which does not care about the day-to-day conditions of dividend payout and the internal funding of projects.

Limitations of Gordon's Model

Some of the most prominent limitations of Gordon’s model include the following −

No External Financing

Like Walter’s model, Gordon’s model also considers projects that rely wholly upon internal financing, having the scope of funding a project without external help. While it is easy to propose so, in real world conditions, it is hard to find firms that do not rely on external funding, via debt or equity, partially or in entirety.

Gordon’s model is therefore more of an ideal situation where a share of a firm remains in an imaginative situation where no external effect can change its nature. This is not true in the real world scenario.

No Change in Internal Return

Gordon’s model also considers a firm’s project that has a constant internal rate of return irrespective of the position of the project in market value terms. It is not only impractical to think of a project which has constant internal return but it is also against the nature of investments that are done via equity or debt sourced externally. Therefore, although it is easy to have an internal rate of return that does not change over time, it is hard to get such a project in reality. Gordon’s model is therefore applicable to imaginative dividend policy of a firm.

Constant Opportunity Cost of Capital

Gordon’s model also relies on a theory of constant opportunity cost of capital that remains constant over the entire life of the project. This is very hard to find in reality. While it is easy to fathom a share that does not have any risk that is an indirect effect of constant cost of capital, it is almost impossible to find such shares in practice.

Shares are market regulated and they always have risks of a certain amount. Therefore, thinking about a dividend policy that has shares with no change in risk is wrong to idealize in practice.

No Corporate Taxes

Gordon’s model relies on the theory that a corporation under consideration has no taxes which is not found in the real world. All corporations usually have to pay tax which may be palpable enough not to ignore it. Therefore, Gordon’s model is not free from flaws in terms of real-world scenarios.

raja
Updated on 25-Mar-2022 05:17:14

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