Question

1. Explain the Gordon growth model (GGM) of stock market equity valuation. What are the major mathematical simplifying assumptions in this model? What are the implications of these simplifying assumptions for application of the model to REIT valuation? 30 points.

Answer 1

Gordon Growth Model :

It is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. The model assumes a cosntant growth rate, it is generally used for companies with stable growth rates in dividends per share.

Value of stock = D1/(r-g)

g= constant growth rate expected dividend

r= constant cost of equity capital of company (the rate of return)

D1= Value of next year's dividend.

Assumption of Gordon Growth Model :

1. The firm is an all equity firm.

2. Only the retain earning are used to finance the investments.

3. No external source of financing is used,

3. The rate of return (r) and cost of capital (k) are constant.

4. The life of firm is indefinite.

5. Retension ratio once decided remains constant.

Implication:

A growth firm's internal rate of return (r) > cost of capital (k). it benefits the shareholder more if the company reinvests the dividend rather than disturbing it. So, the optimum payout ratio for growth firms is zero.