The expected pretax return on three stocks is divided between dividends and capi

Question

The expected pretax return on three stocks is divided between dividends and capital gains in the following way:

Stock Expected Dividend Expected Capital Gain

A $0 $10 B 5 5 C 10 0

a. If each stock is priced at $100, what are the expected net percentage returns on each stock to (i) a pension fund that does not pay taxes, (ii) a corporation paying tax at 45% (the effective tax rate on dividends received by corporations is 10.5%), and (iii) an individual with an effective tax rate of 10% on dividends and 5% on capital gains? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.)

b. Suppose that investors pay 40% tax on dividends and 10% tax on capital gains. If stocks are priced to yield an after-tax return of 10%, what would A, B, and C each sell for? Assume the expected dividend is a level perpetuity. (Do not round intermediate calculations. Round your answers to 2 decimal places.)

Stock Expected Dividend expected capital gain a 0 10 b 5 5 c 10 0

Explanation / Answer

a. Calculating the net expected return on each stock for each of the investors as follows:

[Dividend (1-tax rate) +Capital Gains(1-tax rate) ]/100

(b)

Stock Pension Investor Corporation Individual A 10% 5.50% 9.50% B 10% 7.23% 9.25% C 10% 8.95% 9%

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