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. 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

The pre tax required return is computed as shown below:

Gecko's capital gain will be equal to growth rate of 10% with no taxes, so the after tax return of 10%

Use the after tax return of 10% or 0.10 to solve for capital gains yield "x" for Gordon (since the after tax returns are equal):

0.10 = x + 0.06(1 - 0.40)

0.10 = x + 0.036

x = 0.10 - 0.036

x = 0.064

add back the pre-tax dividend yield i.e.

= 0.06 + 0.064

= 0.124 or 12.40%

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