Corporate Finance Report: Gordon Theory and Capital Structure Analysis

This report delves into the realm of corporate finance, specifically examining the concept of capital structure and its relationship with dividend policy. The analysis centers on the Gordon model of dividend policy, which evaluates the impact of dividend payout on a company's share price. The report explores the model's assumptions, including an all-equity capital structure and the use of retained earnings for investment. It further examines how the Gordon model assesses the market value of a company's shares under different scenarios such as normal, growth, and declining firms. The report concludes that investors tend to value current dividends more than future capital gains, influencing a firm's decision on whether to pay dividends or not based on its type. The analysis highlights the significance of capital structure decisions in minimizing the cost of capital and maximizing the company's market value. The report emphasizes that the optimum capital structure is dependent on the type of firm and its strategic financial decisions.

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Corporate finance
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Table of Contents
“There are no underlying principles of what constitutes optimum capital structure and given that
time, it is most situational”..............................................................................................................2
Evaluating the above statement in terms of Gordon theory:...........................................................2
Conclusion:......................................................................................................................................3
References:......................................................................................................................................4

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“There are no underlying principles of what constitutes optimum capital structure and
given that time, it is most situational”.
This statement is criticized in terms of dividend theory and providing the justification of
whether dividends should be paid by company or not.
Optimum capital structure is the appropriate mixture of preferred stock, debt and
common stocks that helps in minimizing the cost of capital and maximizing the market value of
company. The capital structure of the firm is affected by the payment of dividends. There exist a
conflicting view about the dividend policy of the firm due to the change in the capital structure
(Kurshev and Strebulaev 2015). The statement that there is no underlying principles of what
constitutes optimum capital structure is explained with the help of one of the theories of dividend
policy that is Gordon model.
Evaluating the above statement in terms of Gordon theory:
It is stated by the Gordon theory of the dividend policy that the market price per share of
the company is impacted by the dividend payout policy of the company and the relationship
between the cost of capital and the required rate of return. It is assumed by the model that the
capital structure of company do not comprise of debt and is an all equity company. In addition to
this, the model assumes that the retained earnings is enough to finance the investment of the
company and there is no requirement of external financing. Furthermore, all the investments
made by the business are evaluated by attaching the same level of risk as it assumes a constant
cost of capital. It is indicated by the model that the market value of share of company is the sum
total of present value of the infinite future dividends to be declared. The company is impacted by
the dividend policy as per the Gordon model under different scenarios such as normal firm,

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growth firm and declining firm (Liao et al. 2015). As per the model, for the normal firms, there
is no optimum dividend payout ratio. It is so because there is no difference if the dividend is
distributed to shareholders or reinvested. For the growth firm, the optimum payout ratio is zero
because the shareholder is benefitted when the dividends are reinvested instead of distribution.
It is argued in accordance with the model that there exist a direct relationship between the
market value of share and dividend policy and there is no preference for current dividends by the
investors. The model is built on the premise that the capital gain or the future value of dividend
is evaluated by the investors as uncertain proposition and risky (Öztekin 2015). From the future
capital gain, investors are certain about receiving income. The capital gain is to be discounted by
the higher required rate of return instead of discounting the current dividends due to the
incremental risk associated with the capital gain.
Conclusion:
Therefore, from the analysis in light of Gordon model of dividend, it is inferred that the
current dividends are valued more by investors compared to the expected future capital gain.
Moreover, the earning of the firms are discounted at a lower rate when investors are certain
about their returns and places higher value on that particular firm share value. There would be
adverse effect on the price of share due to increase in retention rate and investors seeking higher
rate of return. From the analysis of the facts presented by the Gordon model, the optimum capital
structure is dependent upon the types of firms and depending upon the types, the firm makes
decision whether to pay dividend or not (Ardalan 2017).

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References:
Ardalan, K., 2017. Capital structure theory: Reconsidered. Research in International Business
and Finance, 39, pp.696-710.
Kurshev, A. and Strebulaev, I.A., 2015. Firm size and capital structure. Quarterly Journal of
Finance, 5(03), p.1550008.
Liao, L.K., Mukherjee, T. and Wang, W., 2015. Corporate governance and capital structure
dynamics: an empirical study. Journal of Financial Research, 38(2), pp.169-192.
Öztekin, Ö., 2015. Capital structure decisions around the world: which factors are reliably
important?. Journal of Financial and Quantitative Analysis, 50(3), pp.301-323.