The Gecko Company and the Gordon Company are two firms whose

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 7 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 30 percent. Gecko has an expected earnings growth rate of 9 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

Solution

Gecko Pays no dividend, i.e., Gecko\'s stock will have only capital gain and since there are no taxes, the after tax return on Gecko\'s stock will be equal to its pretax return.

After tax return on Gecko\'s stock = Capital gain yield or growth = 9%

This is also the after tax return of Gordon\'s stock.

After tax return on Gordon\'s stock = Dividend yield x (1 - tax rate) + Capital gain yield

or, 9% = 7% x (1 - 0.30) + Capital gain yield

or, Capital Gain yield = 4.10%

Pre tax return on Gordon\'s stock = Dividend yield + Capital gain yield = 7% + 4.10% = 11.10%