What is Gordon's Dividend Model?

Finance ManagementBanking & FinanceGrowth & Empowerment

Myron Gordon proposed a dividend model that included some more assumptions than the Walter's model. Gordon's model increased the assumptions of Walter's model and it reflected the evaluation of projects of those firms that have palpable tax and cost of capital greater than growth rate.

Gordon's model has all the assumptions of Walter's model. In addition, it has three more assumptions which include −

  • No Taxes − No corporate taxes should exist with the firm.

  • Constant Retention Ratio − The Retention ratio is constant and does not change with changing income or expenses.

  • The cost of capital is greater than the growth rate. In such a circumstance, the discount rate is greater than the growth rate of the firm.

According to Gordon’s model, the market value of a stock is equal to the value of dividends that are infinite in number. That means, a firm’s share value is equal to the stream of dividends the corporation has in its portfolio.

The following assumptions are common in both Gordon's dividend model and Walter's model −

  • An all-equity firm − To be considered under Gordon's model, the firm should be an all-equity one.

  • No external financing − Like Walter’s theory, Gordon's model assumes the firm having no external financing, that is, no debt or equity sourced from the market.

  • Constant internal rate of return − The firm under Gordon's model must have a constant internal rate of return.

  • Risk remaining the same −The risk associated with an investment project under Gordon's model must remain the same as the cost of capital is considered to be the same during the different phases of the project.

Constant cost of capital is also meant to make the project less flexible under the uncertain circumstances of risk. Although risk does not remain same in all parts of a project, Gordon's model assumes it to remain fixed in order to deduce the value of dividends distributed in an all-equity situation.

Conclusion

Gordon's model is a more acceptable theory than Walter's dividend model, but it is not error-free. Many of the assumptions of Gordon's model are not applicable in practice and the theory fails to show an ideal dividend policy that would be applicable in practical terms. However, the theory is still considered as one of the most important ones in evaluation of dividend policy for an investment project of a market-listed firm.

Gordon's theory also fails in eliminating the repercussion of ups and downs a share undergoes in the market. It considers a rigid stock that is risk-free and perpetual in offering dividends to the shareholders.

raja
Updated on 03-Mar-2022 10:18:47

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