Gordon's Model and MM Model of Dividend Policy

Gordon’s model and MM model

Gordon's Model and MM Model of Dividend Policy

1. Gordon's Model

Myron Gordon's Model is a dividend relevance theory. It states that the dividend policy of a company affects the market value of its shares.

The model is based on the idea that investors generally prefer certain current dividends rather than uncertain future capital gains. This is often referred to as the "bird-in-the-hand" argument.

Gordon's Formula

$$                        $$

Where:

• P₀ = Current market price per share
• E = Earnings per share
• b = Retention ratio
• r = Rate of return on investment
• Ke = Cost of equity capital

Dividend payout ratio = 1 − b

Main Principle

The relationship between r and Ke determines the appropriate retention/dividend approach:

Situation	Implication
r > Ke	Higher retention can increase share value
r < Ke	Higher dividend payout can increase share value
r = Ke	Dividend policy has no effect on share value

Assumptions of Gordon's Model

• The company is an all-equity firm.
• No external financing is used.
• The rate of return r remains constant.
• The cost of equity Ke remains constant.
• The retention ratio remains constant.
• The firm has an indefinite life.
• Corporate taxes are not considered.

2. MM Model of Dividend Policy

Miller and Modigliani (MM) proposed the Dividend Irrelevance Theory in 1961.

According to MM:

Dividend policy does not affect the market value of the firm.

The value of the firm depends mainly on its earning capacity and investment decisions, rather than on how profits are divided between dividends and retained earnings.

Main Idea

Profit → Dividend + Retained Earnings

According to MM, changing the proportion between dividend and retained earnings does not change shareholders' total wealth, assuming the model's conditions hold.

MM Assumptions

1. Perfect capital markets exist.
2. There are no taxes.
3. There are no flotation or transaction costs.
4. Investors have rational behaviour.
5. Investment policy of the company remains constant.
6. Investors have free access to information.
7. There is no difference between internal and external financing costs.
8. The company's future earnings are known with certainty.

 

MM Formula

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Where:

• P₀ = Current market price per share
• D₁ = Dividend per share at the end of the period
• P₁ = Market price per share at the end of the period
• Ke = Cost of equity

 

 

Gordon vs MM Model

Basis	Gordon's Model	MM Model
Theory	Relevance theory	Irrelevance theory
Dividend policy	Affects firm value	Does not affect firm value
Investor preference	Prefers current dividends	Dividend preference does not determine value
Main factor	Dividend and retention policy	Investment policy and earning capacity
Approach	Bird-in-the-hand	Dividend irrelevance
Taxes/transaction costs	Generally ignored	Ignored
Main conclusion	Dividend policy is relevant	Dividend policy is irrelevant

 

 

 

 

 

 

 

 

 

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