This post uses the Gordon growth model to considers
how onetime changes in the cost of capital or onetime changes in dividend payments
impact share prices. The example
presented here assumes a constant growth rate in dividends.
Question: Consider a firm with two possible cost of
capital estimates – 7% percent and 9%. The
initial forward dividend is either $3 dollars per share or $4 per share. Use the Gordon growth model to calculate the
share price for the four combinations of dividend per share and cost of capital,
assuming constant dividend growth of 3 percent.
Set up a spreadsheet so that share
prices can be calculated for different values of forward dividends, the cost of
capital and the dividend growth rate.
Background: The
Gordon Dividend Growth Model treats the value of a stock as the discounted
value of all future dividends.
The formula for the value of the
stock can be written as
P=D/(RG)
P is the value of the stock,
D is the annual dividend,
R is the required cost of
equity,
G is the growth rate of
dividends.
Resource on Gordon Growth Model.
The Spread Sheet
The spreadsheet used to
calculate share prices for this application of the Gordon growth model is presented below.
Dividends
Per Share


Cost
of Capital

3

4

%
Increase in stock price due to increase in dividends per share

0.07

$75.0

$100.0

33.3%

0.09

$50.0

$66.7

33.3%

%
Decline in Stock Price given Increase in cost of capital

33.3%

33.3%


Growth
Rate of Dividends

0.03

The assumptions on cost of
capital are places in the far left column.
The dividend per share
assumptions are placed in the two center columns of the first row.
The assumption on the growth
rate of dividends is places in the bottom row, second column.
The
share price figures in the middle of the spread sheet are calculations based on
the Gordon growth model from the formula P=D/(RG).
Results:
An increase in dividend per share
from 3% to 4% leads to a 33.3 % increase in share price
An increase in cost of
capital from 7% to 9% leads to a 33.3% decrease in share price.
A simultaneous increase in
the cost of capital and decrease in dividend payments leads to a decrease in share
price from $100 to $50.
Question: What happens if the cost of capital rises to
8 percent rather than 9 percent.
Comment: Reader after constructing this spreadsheet
can confirm increase in cost of capital will result in share price falling by
20 percent.
Concluding Remark: This scenario involving a
simultaneous increase in the cost of capital and dividend reductions is fairly
realistic because increases in cost of capital could prompt management to
reduce dividend payments.
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