Question

The Gecko Company and the Gordon Company are two firms whose business risk Is the same but that have different dividend policles. Gecko pays no dividend, whereas Gordon has an expected dividend yleld of 5 percent Suppose the capital galns 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 Intermedlate calculations and enter your answer as a percent rounded to 2 declmal places, e.g., 32.16.) 9% Pretax return

Answer 1

Gecko Earnings growth rate = 11%

Since no Capital gains tax for Gecko after Tax returns = Before tax returns = 11%

Gordon Dividend yield = 5%

After tax returns = 5%* (1-.35%) = 3.25%

if dividend payout is 100%,

Gordon’s pretax return = 11%/ (1-35%) = 16.92%