Question

As discussed in the text, in the absence of market imperfections and tax effects, we would expect the share price to decline by the amount of the dividend payment when the stock goes ex dividend. Once we consider the role of taxes, however, this is not necessarily true. One model has been proposed that incorporates tax effects into determining the ex-dividend price:¹

  

(P₀ – P_X)/D = (1 – T_P)/(1 – T_G)

  

where P₀ is the price just before the stock goes ex, P_X is the ex-dividend share price, D is the amount of the dividend per share, T_P is the relevant marginal personal tax rate on dividends, and T_G is the effective marginal tax rate on capital gains.

  

a.	If TP = TG = 0, how much will the share price fall when the stock goes ex?

  

• P_X

• P₀

• D

b.	If TP = 18 percent and TG = 0, how much will the share price fall? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

c.	If TP = 18 percent and TG = 35 percent, how much will the share price fall? (Do not round intermediate calculations and round your answer to 4 decimal places, e.g., 32.1616.)

  

d.

Suppose the only owners of stock are corporations. Recall that corporations get at least a 50 percent exemption from taxation on the dividend income they receive, but they do not get such an exemption on capital gains. If the corporation’s income and capital gains tax rates are both 29 percent, what does this model predict the ex-dividend share price will be? (Do not round intermediate calculations and round your answer to 4 decimal places, e.g., 32.1616.)

Answer 1

Solution:

(Po-Px)/D= (1-TP)/(1-TG)

a) if TP=TG=0

Then Po-Px= D

Therefore Px= Po-D which means share price will fall by amount of dividend D

b) If TP=0.18, TG=0

Then (Po-Px)/D= (1-0.18)/1

Po-Px=0.82D

Px= Po-0.82D which means the share price will fall by 82 % of Dividend.

c) If Tp= 0.18, Tg=0.35

Po-Px/D= (1-0.18)/(1-0.35)

Po-Px= (0.82/0.65)D

Po-Px= 1.26D

Px= Po-1.26D which means the share price will fall by 126 % of Dividend

d) Since corporation are only owners then TP= 0.50*0.29= 0.145

Po-Px/D= (1-0.28)/(1-0.29)                   

Po-Px=1.014D                   

Px= Po-1.014D which means share price will fall by 101.4% of Dividend.