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:

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 $9 B 4 4 C 21 0

Explanation / Answer

Part A)

The formula for calculating return is given as follows:

Return = [Dividend*(1-Dividend Tax Rate) + Capital Gain*(1-Capital Gain Tax Rate)]/Price

______

1) Pension Fund

Pension fund pays no taxes. Therefore, the return percentage will get calculated as follows:

Stock A = [0*(1-0) + 9*(1-0)]/100 = 9%

Stock B = [4*(1-0) + 4*(1-0)]/100 = 8%

Stock C = [21*(1-0) + 0*(1-0)]/100 = 21%

______

2) Investor Corporation

The corporation pays 45% tax on capital gains and 10.5% tax on dividend income. The return percentage for each stock are calculated as follows:

Stock A = [0*(1-10.5%) + 9*(1-45%)]/100 = 4.95%

Stock B = [4*(1-10.5%) + 4*(1-45%)]/100 = 5.78%

Stock C = [21*(1-10.5%) +0*(1-45%)]/100 = 18.80%

______

3) Individual

The individual pays 5% tax on capital gains and 10% tax on dividend income. The return percentage for each stock are calculated as follows:

Stock A = [0*(1-10%) + 9*(1-5%)]/100 = 8.55%

Stock B = [4*(1-10%) + 4*(1-5%)]/100 = 7.40%

Stock C = [21*(1-10%) + 0*(1-5%)]/100 = 18.90%

______

Tabular Representation:

______

Part B)

The price can be calculated with the use of following formula:

Stock Price = [Dividend*(1-Dividend Tax Rate) + Capital Gain*(1-Capital Gain Tax Rate)]/After-Tax Return

______

Using the information provided in the question, we get,

Price of Stock A = [0*(1-40%) + 9*(1-10%)]/10% = $81

Price of Stock B = [4*(1-40%) + 4*(1-10%)]/10% = $60

Price of Stock C = [21*(1-40%) + 0*(1-10%)]/10% = $126

______

Tabular Representation:

Stock Pension Investor Corporation Individual A 9.00% 4.95% 8.55% B 8.00% 5.78% 7.40% C 21.00% 18.80% 18.90%

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.