The shares of A and B both sell for $85 and offer a pretax return of 12%. Howeve

Question

The shares of A and B both sell for $85 and offer a pretax return of 12%. However, in the case of company A the return is entirely in the form of dividend yield (the company pays a regular annual dividend of $7.5 a share), while in the case of B the return comes entirely as capital gain (the shares appreciate by 7.5% a year). Suppose that dividends and capital gains are both taxed at 25%. (a) What is the after-tax return on share A? (b) What is the after-tax return on share B to an investor who sells after 5 years?

Explanation / Answer

a)After-tax Return on Share A:

At t = 1, a shareholder in company A will receive a dividend of $7.5,which is subject to taxes of 25% .

Therefore

After-tax gain =&.5-7.5*0.25 =$5.625

Since the initial investment is $85, the

after-tax rate of return =(5.625/85)*100 =6.62%

b)After-tax Return on Share B:

If an investor sells share B after 5 years

Price =85*(1+0.075)5 =$122

capital gain =122-85 =$37

and is taxed at 25% rate

After-tax gain =37-37*0.25 =$27.75

after-tax rate of return =6.53%

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