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 5 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 25 percent. Gecko has an expected earnings growth rate of 8 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).)

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 5 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 25 percent. Gecko has an expected earnings growth rate of 8 percent annually, and its stock price is expected to grow at this same rate.

Explanation / Answer

The pre-tax return for Gordon can be calculated with the use of following formula:

Pre-Tax Return = Capital Gains Growth Rate (g) + Dividend Yield

The capital gains growth rate can be calculated with the use of after-tax return formula:

After-Tax Return = Capital Gains Growth Rate (g) + Dividend Yield*(1-Tax Rate)

Therefore, Capital Gains Growth Rate (g) = After-Tax Return - Dividend Yield*(1-Tax Rate)

___________

Using the values provided in the question, we get,

Capital Gains Growth Rate (g) = 8 - 5*(1-25%) = 4.25%

Pre-Tax Required Return = 4.25% + 5% = 9.25% (answer)

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