Question

The Gecko Company and the Gordon Company are two firms whose business risk is the same while having different dividend policies. Gecko pays no dividend, whereas Gordon has an expected dividend yield of 3.5 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 28 percent. Gecko has an expected earnings growth rate of 12 percent annually, and its stock price is expected to grow at this same rate. 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

Answer: 12.98%

Step-by-step explanation:

The formula for pre-tax return for Gecko company can be calculated is the addition of the capital gains growth rate(g) and the dividend yield.

To get capital gains growth rate, we will use th e after-tax return formula which is:

= Capital Gains Growth Rate (g) + Dividend Yield × (1-Tax Rate)

Capital Gains Growth Rate (g) will now be:

= 12% - 3.5% × (1-28%)

= 12 - 3.5(72%)

= 12 - 2.52

= 9.48%

Pre-Tax Required Return will now be:

= 9.48% + 3.5%

= 12.98%