Question

The Gecko Company and the Gordon Company are two firms whose business risk is the same but that have different dividend policies. Gecko pays no dividend, whereas Gordon has an expected dividend yield of 3 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 30 percent. Gecko has an expected earnings growth rate of 18 percent annually, and its stock price is expected to grow at this same rate. The aftertax expected returns on the two stocks are equal (because they are in the same risk class). What is the pretax required return on Gordon’s stock?

Answer 1

Answer:

18.9 %

Explanation:

We shall work out this using the below information:

Given that

Dividend yield =3% =0.03

Tax rate = 30% =0.3

Gordon's after-tax return = Gecko's after-tax return (Risk is the same= 18%

Since the capital gains tax is zero, then

Gordon's after-tax return

= Capital gains yield + Dividend yield* (1-tax rate)

0.18 =  Capital gains yield + (0.03 *( 1 - 0.3)

0.18 = Capital gains yield + (0.03*0.7)

0.18 = Capital gains yield + 0.021

0.18 -0.021 = Capital gains yield

Capital gains yield + 0.18 -0.021 = 0.159

The pretax return = Capital gains yield + Dividend yield

                           = 0.159 + 0.03 =0.189

         0.189*100 = 18.9 %