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CMA Intermediate · Financial Management and Business Data Analytics · Dividend Decisions and Dividend Theories

In Gordon's dividend model, which assumption is made about the firm's financing and return on investment?

Gordon's model assumes the firm finances investments entirely from retained earnings, with a constant rate of return r and a constant cost of capital ke. It does not rely on external financing, so the retention ratio determines growth.

  1. AThe firm finances all investments through retained earnings only, with constant r and constant keCorrect
  2. BThe firm uses external debt and equity freely, with r varying yearly
  3. CThe firm has no retained earnings and pays all profits as dividends
  4. DThe firm's cost of capital falls as retention increases

Explanation

Gordon's model assumes all-equity financing with investments funded only from retained earnings. The internal rate of return (r) and cost of capital (ke) are constant. Options involving external financing or changing r contradict these assumptions.

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