Question

S17-13 Expected Return, Dividends, and Taxes [LO2]

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. 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: _____

Answer 1

Step-1, The Calculation of the Growth rate

After-tax return = Growth rate + [Dividend yield x (1 – Tax rate)]

12.00% = Growth rate + [2.90 x (1 – 0.35)]

12.00% = Growth rate + [2.90 x 0.65]

12.00% = Growth rate + 1.88%

Growth rate = 12.00% - 1.88%

Growth rate = 10.12%

Step-2, The pretax required return on Gordon’s stock

Therefore, the pretax required return on Gordon’s stock = Growth rate + Dividend Yield

= 10.12% + 2.90%

= 13.02%

“Hence, the pretax required return on Gordon’s stock will be 13.02%”