The Gecko Company and the Gordon Company are two firms whose business risk is th

Question

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 6 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 40 percent. Gecko has an expected earnings growth rate of 10 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

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

Explanation / Answer

gecko expected growth rate = 10% anually

tax returns = pretax returns = 10%

expected dividend yieldofgordon = 6%

after tax returns = 6(1-0.40)=3.6%

assuming payout ratio is 100%

gordons required pre tax returns = 10/(1-0.40) =16.67%

at pretax return of 16.67% on gordon, the after tax return return of both stocks will be equal

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