Question

It's not 16.92%.

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 5 percent Suppose the capital gains tax rate is zero, whereas the income tax rate is 35 percent. Gecko has an expected earnings growth rate of 11 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

Ans:- In this question, we need to find the Pretax Return on Gordon's company stock.

Pre-Tax Return for Gordon's company stock will be given by Capital Gains growth Rate (G) + Dividend Yield (D).

Since we know that After-tax return is given by G + Dividend yield*( 1 - Tax Rate ).Therefore we can calculate the G i.e capital gain growth rate by this formula

After-Tax return = G + D * ( 1 - Tax Rate )

G = After - Tax return - D * ( 1 - Tax Rate)

G = 11 - 5 * (1 - 0.35) [ since it given in the question that after tax expected return of the both the companies is same i.e 11%, Dividend yield is 5% and Tax rate is 35%]

G = 7.75%

Therefore the capital gain growth rate is 7.75% and we know the Dividend yield is 5%. Now we can calculate the Pre-Tax return of the Gordons company.

Pre-Tax return for Gordon company will be G + D

Pre-Tax return = 7.75% + 5%

=12.75% is the required Pre-Tax growth rate.

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