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 4 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 16 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

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 4 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 16 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).

Explanation / Answer

Tax is imposed on dividend only (Income) and capital gain(Price return) tax is zero

After tax return = 16%

Total Return = Capital gain (Price return)+ Dividend income (1-Tax) = 16%

Capital gain + 4 %( 1-0.3) = 16%

Capital gain =16%-2.8% =13.2%

Thus pretax required rate of return for Gordon

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