Question

I 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, whereaE rate is zero, whereas the income tax rate is 30 percent. Gecko has an expected earnings growth rate of 9 percent annually, and its stock price is expected to grow at this same rate Gordon hes an expected dividend yield of 6 percent. Suppose the capital gains ta If the aftertax expected retums on the two decimal places, 8.g, 32.16.) 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 Pratax raturn Check my work

Answer 1

Solution-

Dividend yield of Gordon company = 6%

Capital gain tax rate = 0

Income tax rate = 30%

Earning growth rate = 9%

Pre tax return of Gordon stock = dividend yield before tax + capital gain yield

After tax return = capital gain yield + dividend yield (1- tax)

9%= capital gain yield + 6%*(1-0.30)

Capital gain yield = 9% - 4.2%= 4.80%

Pre tax return of Gordon stock = 6% + 4.80%= 10.80%

Pre tax return =10.80%