The Gordon Model

Topics: Stock market, Stock, Cash flow Pages: 5 (1210 words) Published: January 9, 2013
Coursework Assignment Number 1

The Gordon Model is particularly useful since it includes the ability to price in the growth rate of dividends over the long term. It is important to remember that the price result of the Constant Dividend Growth Model assumes that the growth rate of the dividends over time will remain constant. This is a difficult assumption to accept in real life conditions, but knowing that the result is dependent on the growth rate allows us to conduct sensitivity analysis to test the potential error should the growth rate be different than anticipated.

estimate of the present value of shares in Latrike plc

The following table is a record of dividends for a pharmaceutical company Latrike plc.

|Dividend per Share  |2011 |2010 |2009 |2008 |2007 | |In pence. | | | | | | | |70.00p |65.00p |61.00p |57.00p |53.00p |

Where [pic] is the price, at time zero, of a share.
[pic] is the dividend expected at the end of a period
[pic] is the return expected by investors during the period
[pic] is the growth rate of dividends, estimated for the period. The cost of equity share capital of Latrike estimated to be 11% per annum at this time.

From the above table, we can know:(Arnold, G. 2007)
So the present value of shares in Latrike plc is 19.74[pic]

2.estimated share price change if the return expected by investors were to increase to 12%

If the return expected by investors were to increase to 12%, then [pic][pic]
share price change=1974p-1563p=411p

Why might investors require an increased return from shares in Latrike plc?

The reason why investors are willing to invest,because the requirement of return expected by investors is high enough. And it can cover the perceptible risk of investment.If a person buys a stock, that person may desire a high required rate of return. Required rate of return is an important index for investors to evaluate the company dividend.It reflects the investors from the dividend yield of the stock investment. It is one of important index that the investors Judging investment risk and measure the investment income. High required rate of return illustrate the company has a good return on investment. And investors usually tend to buy high dividend rate of return of stock exactly. That's why might investors require an increased return from shares in Latrike plc.(Jing xin,Wang huacheng,Liu yunyan2009)

Consider the problem of estimating dividend growth in the above equation and any alternative methods of setting a number for [pic] other than the one you chose in answering part 1.

The parameters in the model prediction and estimation with high subjectivity and uncertainty.The hypothesis is very sensitive. Take the case of computational formula above. If we change the growth assumption to 8 per cent and reduce the required rate of return to 15 per cent, the value of the share jumps to 1072p.(Arnold, G. 2007) [pic]

As the growth rate converges on the required rate of return the value goes to infinity. Different analysis researchers used model although consistent, but in k or g hypothesis has slight difference, ,it will let the share price from calculation at opposite poles.

We can choose another alternative method. Change other formula like [pic]
r :Return on Capital Employed
b: proportion of earnings retained

5.After making your calculation you find that the price of shares in Latrike plc on the London Stock Exchange is £11.25. Consider possible reasons for the difference between this price and the one you have estimated using the dividend growth model.

Calculated from the stock prices using the dividend...

References: 1.Constant Growth (Gordon) Model
Arnold, G. (2007). Essentials of Corporate Financial Management. Harlow: Pearson Education Limited.
3.Jing xin,Wang huacheng,Liu yunyan(2009).science of financial management.Bei jing:China Renmin University Press.
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