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CS Executive · Corporate Accounting and Financial Management · Dividend Decisions

Which of the following is a key assumption of Gordon's dividend model?

Gordon's model assumes the firm is wholly equity financed and funds new investment only from retained earnings. It also assumes constant return on investment and cost of capital, a constant retention ratio, and perpetual life. Hence the statement about reliance on retained earnings is the correct assumption.

  1. AThe firm's cost of capital (k) changes with the retention ratio
  2. BThe firm is wholly equity financed and relies only on retained earnings for new investmentCorrect
  3. CThe internal rate of return (r) of the firm keeps changing every year
  4. DThe firm has a finite life with no terminal value

Explanation

Gordon's model assumes an all-equity firm that finances investment only through retained earnings, with constant r and k and a perpetual life. Option A is wrong because k is assumed constant. Option C is wrong because r is assumed constant. Option D is wrong because the firm is assumed to have an infinite life.

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