Earnings per share of a company is Rs. 5 and the rate of return required by its shareholders is 16 percent. Assuming Gordon's valuation model, what rate of return should be earned on investment to ensure that the market price of its share is Rs. 50 and the dividend payout is 40 percent?

The correct answer is 20 percent. 

• A dividend refers to that part of the net profits of a company that is distributed among shareholders as a return on their investment in the company.
• Dividend policy means the broad approach according to which every year it is determined how much of the net profits are to be distributed as dividends and how much is to be retained in the business.  
• There are three theories for dividend policies: The Walter model, The Gordon growth model, and Modigliani and Miller’s dividend irrelevancy theory.

Key PointsGordon's model:

• Myron Gordon proposed a dividend model that included some more assumptions than Walter's model.
• Gordon's model increased the assumptions of Walter's model and it reflected the evaluation of projects of those firms that have palpable tax and cost of capital greater than the growth rate.
• According to Gordon’s model, the market value of a stock is equal to the value of dividends that are infinite in number.
• That means a firm’s share value is equal to the stream of dividends the corporation has in its portfolio.

The Gordon Model formula is written as:

P = D1 / r – g
P = Value of current stock price 
g = Constant growth rate 
r = Constant cost of equity capital  
D1 = Dividend value (at the end of 1st year)

Important Points In the given scenario, 
Earnings = Rs. 5
R = 16 percent.
P, Market price= Rs. 50
Payout ratio = 40%

Dividend = Earnings x Payout ratio 
= 5 x 40%
= Rs. 2

P = D1 / r – g
50 = 2/ R – 0.16
R-0.16 = 2/50 = 0.04
R = 0.04+0.16 = 0.20 
R= 20%

Hence, the correct answer is 20 percent.