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 35 percent. Gecko has an expected earnings growth rate of 11 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 ?

Answer 1

Answer: Expected earnings growth rate for Gecko is given as 11% annually

Expected Dividend yield of Gordon= 5%

No capital gains means after tax returns is equal to Pre - tax returns for the stock =11%

After tax expected return for both are equal

After tax required return = Earnings growth rate + Dividend yield *(1- tax rate)

11% = Earnings growth rate + 5 *(1-.35)

Earnings Growth rate = 11% - 3.25%

Earnings growth rate = 7.75% for Gordon

Pre-tax required return = Earnings Growth rate + Dividend yield

Pre- tax required return = 7.75% + 5%

Pre- Tax required return = 12.75% on Gordon's Stock