Page 206 - DMGT409Basic Financial Management

Unit 13: Theory and Forms of Dividend

6. The retention ratio (b) once decided upon is constant. Thus, the growth rate (g) is also Notes
constant (g=b ).
r

7. The growth rate of the firm is product of its retention ration and its rate of return. i.e.
g= b . It is constant.
r
8. A corporate tax does not exist.
Gordon used the following formula to find out price per share

E1 )
( - b
P = 1
K - b r
P = price per share
K = cost of capital
E = earnings per share
1
b = retention ratio
(1-b) = payout ratio
g = b growth rate. (r = internal rate of return)
r
Implications with points according to Gordon

1. When R>K, the price per share increases as the dividend payout ratio decreases.
2. When R<K the price per share increases as the dividend payout ratio increases.
3. When R=K the prices per share remains unchanged in response to the change in the payout
ratio.

Note Gordon’s view on the optimum dividend payout ratio can be summarized as
below:

1. The optimum payout ratio for a growth firm (R.K) is zero.

2. There is no optimum ratio for a normal firm (R = K).

3. Optimum payout ratio for a declining firm R<K is 100%.
Thus, the Gordon’s Model’s conclusions about dividend policy are similar to that of Walter. This
similarity is due to the similarities of assumptions of both the models.
Illustration 2: If K= 11% and earnings per share is `15. Calculate the price per share of Sushma
Ltd. For r = 12%, 11% and 10% for the following levels of D/P ratios.
D/P ratios Retention ratio
1. 10% 90%
2. 30% 70%
3. 50% 50%

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