Radiant Corporation, a market leader dealing in refrigeration products, has been paying dividend consistently over last several years The growth rate of dividend on an average has been 12%

The Dividend discount model (DDM) or Gordon Model is a quantitative model to value a company's stock price based on the theory that its stock is worth the sum of all of its future dividend payments, discounted back to their present value. The model works fairly well in case of large mature companies which has stable growth and pays out almost all of its free cash flows.

Case 1: Company does not invests in the current technology and continues with the current dividend strategy. It is assumed that company will pay expected Dividend (D1 ) of Rs 12 next year and grows at the expected growth rate of 12% every year.

a) Expected Divided (D₁)                 :                 Rs 12.0

Stable Growth rate (g) :                 12%

Cost of equity (r) :                 16% (capitalization rate is given)

As per Dividend discount model, Price of a stock is given by

           P               =               D₁ / (r-g)                , where D₁ is the expected dividend next year  

Putting in the values, we get

           P               =               Rs 12.0 / (0.16-0.12)

                             =               Rs 300.0

Case 2: Company invests in the new technology and forgoes dividends for next 3 years. In year 4, company pays dividend of Rs 12 which grows at 14% every year.

Using the above dividend discount model, we will get the expected share price at the end of year 3. (given dividend will start from year 4).

Expected Divided (D₄)                 :                 Rs 12.0

Stable Growth rate (g)                 :                 14%

Cost of equity (r)                          :                 16% (capitalization rate is given)

Putting in the values, we get

           P₃ =               Rs 12.0 / (0.16-0.14)

                            =               Rs 600.0

This is the expected Price at the end of Year 3. We need to discount this Price using the capitalization rate of 16% to today.

P₀                 =               P₃ / (1 + r)^{^3}

                            = Rs 600 / (1 + 0.16)^3 = Rs 384.39

Hence, with the above news, company's share price is expected to react positively and increase from Rs 300 to Rs 384.39.

However, please note that in reality, due to deferment of dividend, market might require a higher capitalization rate linking it with the increased risk (let's say execution risk of new project) or the exisitng shareholders are retired persons who were dependent on the dividends. They might sell the shares leading to fall in share price in the short term.

Comments on Dividend Policy

Dividend policy concerns company's policies regarding paying dividend in the present or paying an increased dividend at a later stage. Dividend policy can depend on lot of fators such as Earnings trend, Stability in earnings, nature of industry, maturity of company, future financial requirements, kind of sharedholder base, Legal Restrictions, taxation policy etc. In this case, company had to decide between paying dividend growing at a rate of 12% or using the excess cash for new investments, stopping the dividends for next 3 years and then paying the dividend at increased growth rate of 14%. There are various theories on dividend policy arguing that dividend policy does increases shareholder's wealth (Walter's and Gordon's model) and vice-versa (Miller Modigliani model).

As per Gordon's theory, dividends paid by companies are viewed favourably by the investors and companies which do not pay dividends are rate adversely affecting the share price. Consistent dividends reduce uncertainty of the shareholders i.e. the earnings of the firm is discounted at a lower discount rate, thereby increasing the market value. However, its exactly opposite in the case of increased uncertainty due to non-payment of dividends.