Question

A company has a retention ratio of 65%, net income of $85 million, and 12 million shares outstanding. How much should an investor pay now for a stock expected to sell for $60 one year from now if dividends are taxed at 40%, capital gains are taxed at 20%, and a 22% after-tax return is expected on the investment?

Answer 1

After tax Dividend per share = $85,000,000 X (1-65%) / 12,000,000 X (1-40%) = $1.4875

Purchase price = (Selling price of stock + after tax dividend– taxes on capital gain) / (1+ required rate of return)

= [$60 + $1.4875 – (selling price of stock – purchase price) X 20%] / (1+22%)

1.22 purchase price = $61.4875 – ($60 – purchase price) X20%

1.22 purchase price = $49.4875 + 0.2 purchase price

Purchase price = $49.4875/ (1.22 – 0.2) = $48.5172

Stock can be bought for $48.5172

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