Application of Gordon Growth Model and Investment Appraisal Methods

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Financial Management
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Table of Contents
1...................................................................................................................................................................3
a).............................................................................................................................................................3
b).............................................................................................................................................................5
c).............................................................................................................................................................7
3...................................................................................................................................................................9
A..............................................................................................................................................................9
B............................................................................................................................................................14
Conclusion.................................................................................................................................................16
References:................................................................................................................................................17
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1.
a)
Gordon growth model is the one which is used to determine the intrinsic value of a stock, which
is derived from the past dividends which are subject to growth (Wallstreetmojo, 2019). The
formula for the Gordon Growth model is:
Wherein,
P= Current price of a stock
D1= Value of next year’s dividend
R= cost of capital or the rate of return
G= growth rate of dividend
In order to find the share price of Gordon’s share the following calculations have been carried
out:
Given Information:
Year Dividend rate
0 13%
1 14%
2 17%
3 18%
4 20%
Cost of Capital 14%
Valuation of Share = D1(1+g)
K-g
3

Valuation of Share = 20*(1+0.113)
.14-.113
Valuation of Share = 22.26
0.027
Valuation of Share = 824
Working Notes
Calculation of growth rate
D1 = D0(1+g)
(1+g) =
(1+g) =
(1+g) =
(1+g) = 1.113708
Growth rate = 1.113708-1
Growth rate = 11.37%
Conclusion:
The fair price of Planet’s share at the rate of return of 14% is 824.
4
∜(D0/D1)
∜(20/13)
1.538∜

b)
When a firm decides to increase its share of debt, the risk associated with it also increases. The
reason for the increased risk is the increased obligation of interest payment and increased
obligation of principal amount repayment. All this directly increase the wealth and earnings after
tax and interest of a company. Therefore, it is essential that a firm takes these decisions with due
care.
As the required rate of return of Planet's shareholders increases from 14% to 15.4%, it is
definitely going to affect the share prices of the firm.
The calculation for the changed share price is as follows:
Given Information as per the question :
Year
Dividend
rate
0 13%
1 14%
2 17%
3 18%
4 20%
Cost of Capital 15.40%
Valuation of Share = D1(1+g)
K-g
Valuation of Share = 20*(1+0.113)
.154-.113
5

Valuation of Share = 22.26
0.041
Valuation of Share = 543
Calculation of growth rate
D1 = D0(1+g)
So here
(1+g) =
(1+g) =
(1+g) =
6
∜(D0/D1)
∜(20/13)
1.538∜

(1+g) = 1.113708
Growth rate = 1.113708-1
Growth rate = 11.37%
Conclusion:
The fair price of Planet’s share after the increased required rate of return by equity shareholders
is 543.
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c)
Gordon growth model:
Gordon growth model is used to find out the intrinsic value of the stock by discounting the future
dividend payments that a company pays to its shareholders.
It has some of the assumptions listed as follows:
 The company has a constant growth rate.
 The required rate of return or the equity shareholders rate of return is constant.
 The required rate of return is always greater than the growth rate of the firm.
 The firm exists for an indefinite time or a long time in the future (Ozyasar, 2019).
The Gordon growth model has a number of disadvantages when it is applied in real life business
circumstances. Some of the disadvantages are listed as follows:
 The Gordon growth model ignores all the factors such as brand loyalty, customer retention,
ownership of intangible assets for the valuation of the stock. All of these factors are
considered to increase the value of the stock to a certain level. Therefore, ignoring such
crucial factors does not result in the correct valuation of stock as far as practical business
circumstances are concerned.
 This model suffers from the major limitation that a company's dividend always grows. This
does not hold true in actual business circumstance because it is not necessary that a firm will
always grow its dividend. This is a major drawback of the Gordon growth model. Also, the
future dividend that a firm is going to pay cannot be predicted accurately in real life business
circumstance (Readyratios, 2019).
 The Gordon growth model suffers from the limitation that it is based on various assumptions.
These assumptions just exist in the theory. It is not possible for a business to operate in the
ideal assumptions that the Gordon growth model presumes.
 This model also presumes that the dividend growth rate never exceeds the cost of equity.
This might not always be true for practical business circumstances. Also, it assumes that the
prices of stock of a firm just depend upon the dividends that a firm pays. In other words, the
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Gordon growth model ignores the non-dividend factors which affect the price of the stock in
a huge way.
 As this model is based on a number of inputs such as growth rate, the dividend for next year,
etc. it suffers from the limitation that it requires precision and accuracy of these inputs. If the
inputs collected are not accurate and precise then the entire resultant output changes to a
different level. Therefore, it requires a lot of precision while collecting the data. If the data
collected is not accurate then the price of the stock so calculated will also be incorrect.
 This model ignores the fact that the dividends are not always linear or growing. It is nearly
impossible for a company to always pay higher and constantly paying dividends to its
shareholders.
 As the model does not take into account the nonquantitative factors or qualitative factors that
affect the prices of stock of a firm, it is not a very reliable model to find out the value of the
stock (Wallstreetmojo, 2019).
 This model does not take into account the future changes that might happen in real life
business circumstance. This is a major drawback of this model.
 This model is not at all suitable for the companies which do not have a constant dividend
pattern. Therefore, it is majorly suitable for the firms which can predict that their dividends
would be constant.
Conclusion:
Gordon growth model is an easy method of finding the value of the stock. However, as it is
based on various unrealistic assumptions, it cannot be suitable for real-life business
circumstances.
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3.
A.
Lovewell Limited is the food manufacturing company which able to expand their business
process for which they need to purchase new machinery so that they are able to supply high
demand in the market.The company needs to evaluate the performance of machinery in the near
future to identify the profitability of business activities (Hicks, 2017).There are some of the
investment appraisal technique is used to evaluate the performance on the basis of various
aspects in near future which can helpful for a business to determine adequate decision related to
purchasing of new machinery for their business.
Payback Period for project
The payback period is defined as the period on which company can achieve their cost of the
project through their revenue generation from business activities (Aydin, et.al, 2018). This tool
helps management to identify the year in which company can earn profit and also cover their cost
of the project which they bear from purchasing of new machinery.
Discounted Payback
Period = Completed year + Remaining income for Cost of the project
Annual Income of Next year
Discounted Payback
Period = 4 + 52,080
55,730
As the financial information is analyzed for Lovewell Limited which identified the details related
to the payback period. As the payback period is conducted and it is identified that the company is
able to pay back their cost in 4.93 year which is above 75% of the total life of the machinery.
This figure mainly impacts on the decision-related to purchasing of machinery as it seems that
machine is quite costly so that revenue from machine takes the major part of the life of the
machine to achieve payback point for the project which is 4.93.
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Accounting Rate of Return
Accounting rate of return is the technique which provides details related to profitability and net
return from the project in which management or investor wants to invest their money. ARR is
calculated through the dividing of average investment from net revenue from business activities.
This kind of tools helps management to identify the profitability of particular machinery for
business activities.
Accounting Rate of
Return = Average Net profit X100
Average Investment
Accounting Rate of
Return = 55,730.00 X100
158125.00
Accounting Rate of
Return = 35.24%
Working Notes –
Average Investment =
Initial Investment + Salvage
Value
2
Average Investment = 158125
From this study, it is identified that the Accounting rate of return for machinery purchased by
Lovewell limited provides returns of 35.24% in near future from their operational activities.
Finding from accounting rate of return identified the machinery which Lovewell wants to
purchase provide an adequate rate of return in the market so that company or management can
adopt machinery on the basis of accounting rate of return.
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Net Present value
Net present value is the method which is used by management to evaluate the profitability of the
business and specific project in which they want to invest their money to achieve specific
objectives. Net present value is the net value which is achieved buy company in the near future
from the project. This value provides effective information which able management to invest
their money in the project.
Given Information
Particular Amount ( In £)
Initial Investment 275000
Life of the project 6 Years
Salvage value 41250
Annual cash inflow 85000
Annual cash outflow 12500
Cost of Capital 12%
Net Present Value of the project
Particular Amount ( In £)
Initial Investment 275,000
Net Cash Flow (Annually) 229,277.00
Salvage Value 20,914.00
Net Cash flow ( Outflow) 24,809.00
Lovewell analysis financial information which is given for machinery which company wants to
purchase. As the NPV provides a negative cash flow of 24,809 which provide a suggestion of
rejecting the purchasing decision of business for the machinery. This study guides that
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