nvestors require an after-tax rate of return of 10% on their stock investments.
ID: 2715259 • Letter: N
Question
nvestors require an after-tax rate of return of 10% on their stock investments. Assume that the tax rate on dividends is 30% while capital gains escape taxation. A firm will pay a $4 per share dividend 1 year from now, after which it is expected to sell at a price of $36.
Find the current price of the stock. (Do not round intermediate calculations. Round your answer to 2 decimal places.)
Find the expected before-tax rate of return for a 1-year holding period. (Do not round intermediate calculations. Round your answers to 2 decimal places.)
Now suppose that the dividend will be $8 per share. If the expected after-tax rate of return is still 10%, and investors still expect the stock to sell at $36 in 1 year, at what price must the stock now sell? (Do not round intermediate calculations. Round your answer to 2 decimal places.)
What is the before-tax rate of return? (Do not round intermediate calculations. Round your answer to 2 decimal places.)
Why is it now higher than in part (b)?
The before-tax return is higher because select which ( the smaller /larger) dividend creates a
(Click to select) (greater or lesser) tax burden.
nvestors require an after-tax rate of return of 10% on their stock investments. Assume that the tax rate on dividends is 30% while capital gains escape taxation. A firm will pay a $4 per share dividend 1 year from now, after which it is expected to sell at a price of $36.
Explanation / Answer
a. Current Stock price is calculated according to dividend growth model, ke = d1/p0
d1 = 4*(1-0.3) = 2.8
Ke=10% = 0.1
Hence P0 = d1/ke = 2.8/0.1 =$28
b. Before tax return
Capital gain = 36-28/28 = 0.2857
Dividend yield before tax = 4/36 0.1111
Hence total return = 0.2857+0.1111 = 0.3968 =39.68%
c. After tax dividend = 8*(1-0.3)=$5.6
Hence Current Price is 5.6/0.10 =$56
d. Return on Stock will be 36-56/56 = -0.3571
Return on dividend (before tax) = 8/36 0.2222
Hence Total return is 0.2222-0.3571 =-0.1349 = -13.49%
d2.
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