Another model relating to influence of dividend policy on valuation of the firm in terms of market value of shares was put forward by Myron J. Gordon. It is based on relevance concept of dividend policy. According to him the market value of a share is equal to the present value of dividends to be received by the shareholder.

The assumptions that he has made are almost the same as those by Walters. They are as follows:

(1) The firm is an all-equity firm. It means its capital consists of only equity shares. There is no debt capital.

(2) The firm uses only retained earnings for financing its investment programmes. No external financing is used.

(3) The internal rate of return of the firm (r) is constant.

(4) The cost of capital or the appropriate discount rate (k) of the firm is constant.

(5) The firm has perpetual life and its earnings are also perpetual.

(6) There are no corporate taxes.

(7) The retention ratio (b), once decided upon is constant (retention ratio is the proportion of earnings retained in the business). Thus, the growth rate g = br is constant.

Like Walters, Gordon also contended that dividend policy of the firm is relevant and affects the value of the firm. He says that investors always prefer dividend as current income and not the dividend to be obtained in future, because the investors are rational and are risk averse, that is, they do not like to take risk of uncertain future dividend. They put a positive premium on current dividend income and discounts uncertain future dividends as the current dividend received removes any possibility of risk.

If the firm retains the earnings and does not pay dividend, the investor would get it in future. But receipt of dividend in future is uncertain both in respect of time and amount. Hence, investors prefer current dividend. They place less emphasis on future dividends and so when the firm retains its earning, the value of shares is adversely affected. It goes down. The investors discount the future dividend more than the near dividend. In the Gordon’s model it was also stated that the dividend policy of a normal firm where r = k is irrelevant where all the assumptions are held valid. But looking to reality these assumptions have to be modified. He concluded that even in case of normal firm where r = k, dividend policy does affect the value of the share. This is in sharp contrast to Walter’s contention that investors are indifferent between dividends and retention in case where r = k.

A Bird in hand Argument: As we have seen that investors are rational and are risk-averse, meaning thereby that they do not like to take risk in respect of future dividend. Here risk means the possibility of not getting dividend. Hence, the value of shares of that firm which pay higher current dividend will be higher. The investors discount the distant dividend at a higher rate than the near dividend. This argument is described as ‘a bird-in-the-hand’ argument. Investors believe that a bird in hand is better than two in the bush. It means that what is available today is more valuable than what may be available in futures. As Kirshman has said, “Of two stocks with identical earnings record and prospects, but the one paying a larger dividend than the other, the former will undoubtedly commands a higher price merely because stockholders prefer present to future values…. Stockholders often act upon the principle that a bird in the hand is worth two in the bush and for this reason are willing to pay a premium for the stock with the higher dividend rate, just as they discount it with the lower rate.”

This clearly emphasizes that an investor prefers current dividend than the future dividend, as future is uncertain. The more distant the future is more uncertain it becomes. Hence, when dividend is withheld and earnings are retained, it becomes uncertain whether the dividend would be received at all. Hence, the investors who are rational are prepared to pay a higher premium for shares on which current dividends are paid and would discount the value of shares of a firm which retains its earnings. The appropriate discount rate would increase with increase in retention ratio.

Source: listedall.com