The current prices for Stock A and Stock B are $26 and $17, respectively; and th
ID: 2420842 • Letter: T
Question
The current prices for Stock A and Stock B are $26 and $17, respectively; and the prices of the two stocks are expected to increase 15% and 13% per year in future 5 years, respectively. In addition, stockholders of both stocks are guaranteed dividend payments every year in future five years. Assuming you have unlimited amount of capital to invest and both stocks have same amount of risk, which stock would you choose for your investment portfolio to keep for five years? Assuming your income tax rate for future five years would be 30% and your capital gain would be taxed at the rate of 25% in future five years.
Guaranteed Dividend Payments in Future Five Years:
Year
Stock A
Stock B
1
$1
$ 2.5
2
2
1.7
3
1.5
1
4
1.2
3
5
1.8
2.5
Year
Stock A
Stock B
1
$1
$ 2.5
2
2
1.7
3
1.5
1
4
1.2
3
5
1.8
2.5
Explanation / Answer
Calculation of return on Stock A
Dividend income = ($1 + 2 + 1.50 +1.20 + 1.80) x (1 - 0.25)
= 5.625
Market price after 5 years = 26 x (1.15)5
= 52.30
Capital gain net of taxes = (52.30 - 26) x (1 - 0.30)
= 18.41
Return on stock A = (5.625 + 18.41)/26 x 100 = 92.44%
Calculation of return from stock B
Dividend income (net of taxes) = ($2.5 + 1.7 + 1 + 3 + 2.5) x )1-0.25)
= 8.025
Price after 5 years = 17 x (1.13)5
= 31.32
Capital gain net of taxes = (31.32 - 17) x (1-0.30)
= 10.024
Return on stock B = (8.025 + 10.024)/17 x 100
= 106.17%
Return from stock A is 92.44% while return from stock B is 106.17%. Thus it is clear that investor should invest in Stock B.
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