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 3 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 15 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 intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

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 intermediate calculations. Enter your answer as a percentage rounded to 2 decimal places (e.g., 32.16).)

Explanation / Answer

When there is no capital gain,
The after-tax return for the Gordon Company is the capital gains growth rate, plus the dividend yield (D) * (1-Tax)

Using the constant growth dividend model, we get:
After tax return = g + D(1 – t) = 15%
Solving for g, we get:
0.15 = g + 0.03(1 – 0.30)
g = 0.129 = 12.9%
The equivalent pretax return for Gordon Company is:
Pretax return = g + D = 12.9% + 3.0% = 15.9%

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.