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? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g.. 32.16.) Pretax return

Answer 1

solution : Given data is, Gordon dividend yield = 3.5% Dividend tare = 28% Gecko expected earnings growth rate = 12 % After tax retur= Growthoate & Dividend (1-tax rate) 0.12 = Growth rate + 0.035(1-0.28) 0.12 = Growth rate + 0.035 (0.12) 0012 - 0.0252 = Growth rate Growth rate = 9.48 % 6r) o.oqus pre-tase return = Growth rate & dividend 0.0948 + 0.035 = = 0.1298 = 12.98% pre-tax return of Gordon = 12.98 %