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 8 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 19 percent annually, and its stock price is expected to grow at this same rate. The after tax 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))

Explanation / Answer

Post-tax Ke = D1 / P0 * (1-T) + g ---> For Gecko, Ke = 0 + 19% = 19% (Post-tax required return)

So, now for Gordon company also -----> 19% = 8% * (1-0.35) + g --------> g = 13.80%

For Gordon company, Pre-tax Ke = D1 / P0 + g = 8% + 13.8% = 21.80% (Final Answer)

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