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 7 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 35 percent. Gecko has an expected earnings growth rate of 18 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

As capital gains tax is zero, the after-tax return for the Gordon Company is the sum of capital gains growth rate and the dividend yield times one deducts the tax rate.

Using the constant growth dividend model, we get:

After-tax return = g + D(1 – t) = .18

0.18 = g +0 .07(1 – 0.35)

0.18 = g + 0.07(0.65)

0.18 = g +0.0455

g= 0.18 - 0.0455 =0.1345 or 13.45 %

The pretax return for Gordon’s , with 7% dividend , is:

Pretax return = g + D = 0.1345 + 0.07 = 0.2045 or 20.45%

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