q implications of gordons fundamental

Question

Q. Implications of Gordons fundamental valuation?

Explanation: - The implications of Gordon's fundamental valuation may be as below:

(1) While the rate of return of the firm on its investment is better than the cost of capital the price per share raise as the dividend payout ratio decrease. Therefore the growth firm should distribute smaller dividends and should retain maximum earnings.

(2) While the rate of return is equal to the cost of capital than the price per share remains unchanged and isn't affected by dividend policy. Therefore for a normal firm there isn't optimum dividend policy.

(3) While the rate of return is less than the cost of capital the price per share increases as the dividend payout increases. Therefore the shareholders of declining firm stand to increase if the firm distributes its earnings for such firms.

(4) According to Gordon, the market value of the share is equal to the present value of future stream of dividends. Therefore,

P =       D₁ /  (1+K) ¹ + D₂  / (1+K) ² + ----- + D_t / (1+K) ⁿ

P = Market Price per share

K = Appropriate discount rate to calculate risk and time factors

Gordon's Formula for determining the value of a share:-

P = E x (1-b) / K_e-b_r OR P = D / K_e-g

Where P = Market Price per share                                          E = Earnings Per Share

r = Firm's rate of return                                              b = retention ratio

br = g = Growth rate                                                   (1-b) = D/P ratio

Ke = Cost of Capital