Another theory, which contends that dividends are relevant, is Gordon’s model. This model which opines that the dividend policy of a firm affects its value of the share and firm is based on the following assumptions:
- The firm is an all-equity firm (no debt).
- There is no outside financing and all investments are financed exclusively by retained earnings.
- The internal rate of return (r) of the firm remains constant.
- The cost of capital (k) of the firm also remains the same regardless of the change in the risk complexion of the firm.
- The firm derives its earnings in perpetuity.
- The retention ratio (b) once decided upon is constant. Thus the growth rate of frim (g) is also constant (g=br).
- Corporate Taxes do not exist.
- The retention ratio is always less than 1, i.e. b < 1
worked on the model which considers capitalization of dividends and earnings. The model is also referred to as the dividend growth model. The model considers the growth rate of the firm to be the product of its retention ratio and its rate of return.
The capitalization model projects that the dividend division has a bearing on the market price of the shares. According to Gordon, when r>ke the price per share increases as the dividend payout ratio decreases. When r<k the price per share increases as the dividend payout ratio increases.
When r=ke the price per share remains unchanged in response to the change in the payout ratio.
Thus Gordon’s view on the optimum dividend payout ratio can be summarised as below:
- The optimum payout ratio for a growth firm (r>ke) is zero.
- There no optimum ratio for a normal firm (r=ke).
- The optimum payout ratio for a declining firm r<ke is 100%.
Thus the Gordon’s Model’s is conclusions about dividend policy are similar to that of Walter. This similarity is due to the similarities of assumptions of both the models.
The impact of the dividend growth model can thus be analyzed in three situations:
(1) When the normal capitalization rate is less than the actual capitalization rate: CRnorm < CRact
In such a situation, the shareholder gains more earnings by investing in the company than he expects as a norm. The shareholder would want the firm to retain more than to pay as dividends. If dividend payout is enhanced it will lower the intrinsic value as it lowers the growth rate of a highly profitable company.
(2) Another situation could be where the normal capitalization rate equals the actual capitalization rate: CRnorm = CRact
This situation represents that the company is doing well and shareholders are indifferent as to the level of dividend. If the dividend is declared, it would be reinvested in the companies. Thus, the dividend payout ratio does not affect the intrinsic value of the company.
(3) Where normal capitalization rate is more than actual capitalization rate i.e., CRnorm > CRact :
This situation represents the opposite side of (1) above. Here, the company is not doing well as expected, the shareholders would like to invest elsewhere in more profitable avenues, so dividend payout has to be higher, and intrinsic value of shares accordingly gets enhanced.
The dividend growth model, thus an additional measure of the intrinsic value of shares that may be used to supplement other valuation methods.