The Gecko Company and the Gordon Company are two firms whose business risk is th

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 2 percent. Suppose the capital gains tax rate is zero. whereas the income tax rate is 30 percent. Gecko has an expected earnings growth rate of 17 percent annually, and its stock price is expected to grow at this same rate. 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? (Round your answer to 2 decimal places. (e.g., 32.16)) pretax return

Explanation / Answer

Gecko after tax required return = Growth rate +dividend yield

Gecko after tax required return = 17% + 0

Gecko after tax required return = 17%

Gordon after tax required return = Gecko after tax required return = 17%

Gordon after tax required return = Growth rate +dividend yield

17% =  Growth rate + 2%

Growth rate = 15%

Since there is no capital gain tax , pre tax growth rate is equal to post tax growth rate

Pre tax Growth rate = 15%

Dividend Yield is pre tax = 2%/(1-30%)

Dividend Yield is pre tax = 2.86%

Gordon pre tax required return = 15%+2.86%

Gordon pre tax required return = 17.86%

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