Dividend yield or gordon''s model, Finance Basics

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Dividend yield or Gordon's Model

This model is used to determine the cost of various capital components in particular:

Cost of equity - K_e
Cost of preference share capital (perpetual) - K_p
Cost of perpetual debentures - K_d

a) Cost of equity (K_e)- This can be determined with respect to:

Zero growth firm - P₀ = d₀ Therefore = d₀/P₀

R = K_e

Where: d₀ = DPS

R₀ = Current MPS

Constant growth firm - P₀ = d₀(1+g)/K_eg

Therefore K_e= d₀(1+g)/P₀+g

b) Cost of perpetual preference share capital (K_p)

Recall, value of a preference share (FRS) = Constant DPS/K_p

Consequently: d_p = Preference dividend per share

P_p = Market price of a preference share

c) Cost of perpetual debenture (K_d) - Debentures pay interest charges, which an allowable expenses for tax purposes.

Recall, Value of a debenture (V_d)=Interest charges p.a. in ∞/Cost of debt K_d

Therefore K_d=Int/V_d(1-T)

Whereas: K_d = % cost of debt

T = Corporate tax rate

V_d = Market value of a debenture

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