ACCA Financial Management (F9) Certification Practice Exam

In Gordon's Growth Model approximation, what does 'b' represent?

1. Balance of profits reinvested

2. Percentage of total profits

3. Fixed dividend rate

4. Cost of reinvested funds

The correct answer is: Balance of profits reinvested

In Gordon's Growth Model, 'b' represents the retention ratio or the balance of profits that are reinvested into the firm, rather than distributed as dividends. This concept is central to the model, which is used to estimate the intrinsic value of a stock based on its expected future dividends and the growth rate of those dividends. The model assumes that a company retains a portion of its earnings (denoted by 'b') to facilitate growth, while the remainder is paid out to shareholders as dividends. The growth rate of dividends is derived from the portion of profits retained, highlighting how crucial 'b' is for determining the future value of investments. Essentially, a higher retention ratio indicates that a company is reinvesting more of its earnings to fuel growth, which can lead to higher future dividends. Other choices, while related to financial concepts, do not accurately reflect what 'b' specifically signifies in the context of Gordon's Growth Model. For instance, while the percentage of total profits and the cost of reinvested funds are relevant in financial considerations, they do not pinpoint the balance of profits that are specifically retained for growth purposes as 'b' does. Understanding this will help in effectively applying the model to evaluate stock valuations based on growth expectations.