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(^334) Financial Management
Gordon's model gives us the cost of internally generated common equity, ks
ks = (^) market price
dividend in yea r 1

• 
  
  
  







in dividends

annual growth

ks =

Po

D 1

+ g

which can also be written as:

K g

D

P

s-

0 =^1

Hence the dividend growth rate can be subtracted from the cost of equity capital to get

the present value of the share price which should be the market price according to the

formula.

Walter adjusted the above formula to reflect the earnings retention and rewrote the

equation as:

K rb

D

P

s-

0 =^1

Here, b is the percentage of earnings retained, and r is the expected rate of profitability

from the retained earnings.

It follows from the formula that if the earnings retained gives you a higher return than

the cost of capital, you would get a positive return and the share price would go up and

otherwise the share price would come down because of the higher earnings retained.

Walter's formula highlights the return on retained earnings relative to the average market

rate of return on investment (market capitalisation rate) as the critical determinant of

dividend policy. A high rate of return on retained earnings indicates a low payout ratio,

whereas a low rate relative to the market average indicates the desirability of a high

payout ratio to increase the price of the equity shares.

Therefore to increase the share valuation a company may go in for a higher payout in

the form of a dividend. But this reduces the growth rate of the dividends (keeping all

other things constant) bringing it back to square one.