The Gecko Company and the Gordon Company are two firms that have the same business risk but different dividend policies. Gecko pays no dividend, whereas Gordon has an expected dividend yield of 2.9 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 12 percent annually, and its stock price is expected to grow at this same rate.

Required:
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?

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tutorAnne tutorAnne · Answer 1 · 2021-05-06T03:24:13+02:00

Answer:

Gordon's Pretax return is 13.015%

Explanation:

Dividend yield of Gordon =2.9% =0.029

Tax rate = 35% =0.35

Gordon's after-tax return = Gecko's after-tax return =12 % (This is because the capital gains tax is zero)

Using the formulae

After-tax return of Gordon= Capital gains yield + Dividend yield x (1-tax rate)

0.12 = Capital gains yield + (0.029 x ( 1 - 0.35)

0.12 = Capital gains yield + (0.029 X 0.65)

0.12 = Capital gains yield + 0.01885

Capital gains yield= 0.12 -0.01885 =0.101155

Pretax return is given as

Capital gains yield + Dividend yield

= 0.101155+ 0.029 =0.13015 x 100=13.015%

Therefore, Gordon's Pretax return is 13.015%