Question

Consider equally risky, all-equity financed firms G and D. Both firms are currently trading at $50 per share. Firm G pays no dividends, but firm D pays all its earnings as dividends. In a year from today, the stock of firm G is expected to be at $65 per share. Firm D is expected to pay a $15 dividend per share at the year-end and its stock price at the year-end is expected to be $50 per share. Capital gains are taxed at half the 40% regular income tax rate, but the dividend income is taxed at 30%. Required At what share price should the stock of firm D be trading to-day in a competitive stock market? Show calculations to support your answer.

Answer 1

Now here both the companies are similar in all aspects but the only difference is that the one company pays al its earnings in dividend while other reinvests it and thus give earning in terms of capital gain.

Now in both case the investor would like to be indifferent by investing in any of the companies thus, we will now calculate the earning from one of the companies.

Lets compute the after tax earning in case of both the companies.

Firm D = $15 Tax on Dividend is 30% Thus After Tax earning is 15 *(1-0.3) = $10.5

Firm G = $15 Tax on Capital gain is 20% After Tax earning is 15 * (1 -0.2) = $ 12

While investing in both the companies investors require equal net return in terms of %age.

Here Firm G gives $12 for $50 invested thus Net Return = 12/50 = 24%

Similarly Firm D should give a similar return of investment thus to equate the net returns the stock price will be reduced. So we have same return we require Stock Price = 10.5/x = 24%

X = 10.5/0.24

X = $43.75