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Gordon Model

The document provides a solution to calculating the stock value of Swan Ltd given different dividend payout ratios, retention ratios, costs of equity, and expected rates of return. It shows: 1) When the expected rate of return is greater than the cost of equity (12% vs 11%), the stock value is highest with the lowest payout ratio and highest retention ratio. 2) When the expected rate of return equals the cost of equity (11% vs 11%), the dividend payout ratio does not impact stock value. 3) The stock value is positively correlated with payout ratios when the expected return is less than the cost of equity, and decreases with higher retention ratios.

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Ramesh Thangavel T
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1K views

Gordon Model

The document provides a solution to calculating the stock value of Swan Ltd given different dividend payout ratios, retention ratios, costs of equity, and expected rates of return. It shows: 1) When the expected rate of return is greater than the cost of equity (12% vs 11%), the stock value is highest with the lowest payout ratio and highest retention ratio. 2) When the expected rate of return equals the cost of equity (11% vs 11%), the dividend payout ratio does not impact stock value. 3) The stock value is positively correlated with payout ratios when the expected return is less than the cost of equity, and decreases with higher retention ratios.

Uploaded by

Ramesh Thangavel T
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Q1.

If ke = 11% and E= Rs.15 calculate the stock value of swan Ltd. For (i) r=12% (ii) r=11% (iii) r=10% for the various levels of the D/P ratios.
D/P Ratio (1-b) Retention Ratio

A B C D

10% 20% 30% 40%

90% 80% 70% 60%

50%

50%

Solution:

E (1 b) P ke br
Share Price
Earnings per share Retention ratio Dividend pay-out ratio Cost of equity capital

P
E b (1-b) Ke

=
= = = =

br

growth rate (g) in the rate of return on investment


g=b*r

i.

r>ke (r = 12%, ke=11%) a. D/P ratio b g = = = 10% 90% br = 0.90*0.12 = 0.108

P = 15(1-0.9) / 0.11-0.108 = Rs.750

b. D/P ratio b g

= = =

20% 80% br = 0.80*0.12 = 0.096

P = 15(1-0.8) / 0.11-0.096

= Rs.214.28

D/P Ratio

r=12%

r=11%

r=10%

A B C D E

10% 20% 30% 40% 50%

90% Rs.750 80% Rs.214.28 70% Rs.173.08 60% Rs.158 50% Rs.150

Rs.136.36 Rs.75 Rs.136.36 Rs.100 Rs.136.36 Rs.112.5 Rs.136.36 Rs.120 Rs.136.36 Rs.125

Interpretation:

The above illustration explains the relevance of dividends as given by the Gordons Model. In the given three situations, the firms share value is positively correlated with the pay-out ratio when r< ke and decreases with an increase in the pay-out ratio when r>ke. Thus, firms with a rate of return greater than the cost of capital should have a higher retention ratio and those firms which have a rate of return less than the cost of capital should have a lower retention ration. The dividend policy of firms which have a rate of return equal to the cost capital will, however, not have any impact on its share value.

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