You are considering three stocks with the following expected

You are considering three stocks with the following expected dividend yields and capital gains:

DividendYield

Capital Gain

A14%

0%

B8

6

C0

14

               a) What is the expected return on each stock?

                b) How may transactions costs and capital gains taxes affect your choices among the three (3

               securities?

Solution

we know that D₁/P₀=expected dividend yield

                        g=expected capital gains yield

                        r= (D₁/P₀)+g

now expected rate of return on each stock =expcted dividend yield+expected capital gains

Assume the dividends are paid annually after the capital gain is added to the stock value.

a) A:expected rate of return=14+0=14%

   B:expected rate of return=6%+(8%)*1.06)=6%+(8.48%)=14.48%

   C:expected rate of return=0+14=14%

b)

A: No capital gains tax, tax cost on dividends. If dividends are paid out to stock holder immediately

    otherwise taxed when stock is old.

B: Capital gains tax when stock is old, Tax cost on dividends.

    If dividends are paid out to stock holder immediately.

   otherwise taxed when stock is old.

C: Capital gain tax when stock is old. No dividend costs.