## Cost of Equity: Dividend Growth Model

The Gordon Growth Model assumes dividends grow at a constant rate g indefinitely.

Ke = D₁ / P₀ + g

### Finding g from Historical Dividends

g = (Dₙ / D₀)^(1/n) – 1

Or look up FVIF tables: Dₙ = D₀ × FVIF(g, n)

### Cum-Dividend vs Ex-Dividend Price

Cum-dividend price includes the imminent dividend. Convert:

P₀ (ex-div) = P₀ (cum-div) – D₀

Always use the ex-dividend price in the formula.

### Reverse Applications

Worked example

### Example 1

Q17 — Basic Gordon Model

D₀ = ₹1 (last year); g = 10%; P₀ = ₹55

D₁ = 1 × 1.10 = ₹1.10

Ke = 1.10/55 + 0.10 = 0.02 + 0.10 = 12%

### Example 2

Q19 — Three-part Gordon Model

P₀ = ₹40; D₀ = ₹2 (just paid); g = 10%

(a) D₁ = 2 × 1.10 = ₹2.20

Ke = 2.20/40 + 0.10 = 5.5% + 10% = 15.5%

(b) If g rises to 11%, Ke stays 15.5%:

P₀ = (2 × 1.11)/(0.155 – 0.11) = 2.22/0.045 = ₹49.33

P₀ = (2 × 1.10)/(0.16 – 0.10) = 2.20/0.06 = ₹36.67

### Example 3

Q20 — g from historical data + cum-dividend adjustment (Bharat Ltd)

D₂₀₀₂ = ₹26; D₂₀₀₅ = ₹30; n = 3 years

(1+g)³ = 30/26 = 1.1538 → g ≈ 4.88% (use 5% rounded)

Market price = ₹235 cum-dividend; D₀ = ₹30 just paid

P₀ (ex-div) = 235 – 30 = ₹205

D₁ = 30 × 1.05 = ₹31.50

Ke = 31.50/205 + 0.05 = 15.37% + 5% = 20.37%

### Example 4

Q21 — Finding g given Ke and dividend policy

Dividend = 5% of market price at start of year → D/P₀ = 5%; Ke = 12%

Ke = D₁/P₀ + g → 12% = 5% + g → g = 7%

⚠️ Common exam mistakes

Using D₀ (last year's dividend) directly instead of D₁ = D₀ × (1+g).
Using cum-dividend price — must subtract D₀ to get ex-dividend price before applying the formula.
Computing g by simple subtraction (D_n – D_0)/n instead of the compound formula.
Applying the model when dividends are irregular — Gordon model requires constant perpetual growth.

Reference:

Now that you've read this — what's next?

Move from understanding → mastery in 3 clicks. Each option below picks up from this lesson's topic.

Cost of Equity — Dividend Growth Model (Gordon Model)

Worked example