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 6 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 40 percent. Gecko has an expected earnings growth rate of 10 percent annually, and its stock price is expected to grow at this same rate.

Required:
If 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

12.4%

Step-by-step explanation:

After-Tax Return = Capital Gains Growth Rate (g) + Dividend Yield*(1-Tax Rate)

Capital Gains Growth Rate (g) = After-Tax Return - Dividend Yield*(1-Tax Rate)

Capital Gains Growth Rate (g) = 10 - 6*(1-40%)

Capital Gains Growth Rate (g) = 6.4%

Pre-Tax Return = Capital Gains Growth Rate (g) + Dividend Yield

Pre-Tax Return = 6.4% + 6%

Pre-Tax Return = 12.4%

Hence, the pretax required return on Gordon’s stock is 12.4%