Sikkim Manipal Finanacial Management Ramabhadran
1¬) Briefly explain Walter's and Gordon's theory of dividend?
Gordon's theory
The model opines that dividend policy of a firm affects its value based on following assumptions:
1) The firm is an all equity firm.
2) There is no outside financing and all investments are financed exclusively by retained earnings.
3) Internal rate of return(R) of the firm remains constant.
4) Cost of capital (K) of firm also remains constant regardless of the change in the risk complexion of the firm.
5) The firm derives its earnings in perpetuity.
6) The retention ratio(b) once decided is constant. Thus the growth rate (g) is also constant(g=br)
7) K>g
8) A corporate tax does not exist.
Gordon used the following formula to find out price per share
P = E1 (1-b)
K- br
P = price per share.
K = cost of capital.
E1 = earnings per share.
b = retention ratio.
(1-b) = payout ratio.
g = growth rate
According to Gordon, when R>K the price per share increases as the dividend pay out ratio decreases.
Thus Gordon's view can be summarized as below:
1) The optimum payout ratio for a growth firm (R>K) is zero.
2) There is no optimum payout ratio for a normal firm(R=K).
3) Optimum pay out ratio for a declining firm (Rk 0 % i.e. shouldn't pay any dividend
Normal firm r=k DPR doesn't affect the value of firm
Declining rk, should distribute all earning when r
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