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 6 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 and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Pretax return %

Explanation / Answer

SInce Gecko pays no dividend and there is no capital gain tax ,so its after tax return will be 15%

Also ,if after tax return of both companies are equal ,then after tax return of gordon company will be 15%

after tax return = Capital gain yield + Diviend yield(1-tax)

15 = CGY + 6 (1-.30)

15 =CGY +4.2

CGY = 15-4.2 = 10.80%

So pretax required return on Gordon’s stock = Capital gain yield+ before tax dividend yield

                = 10.80+6

                  = 16.80%

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