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 7 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 35 percent. Gecko has an expected earnings growth rate of 18 percent annually, and its stock price is expected to grow at this same rate. 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’s stock? (Round your answer to 2 decimal places. (e.g., 32.16))

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 7 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 35 percent. Gecko has an expected earnings growth rate of 18 percent annually, and its stock price is expected to grow at this same rate. The aftertax expected returns on the two stocks are equal (because they are in the same risk class).

Explanation / Answer

After-tax expected return for Gecko = 18% (as their is no dividend yield, only capital growth)

After-tax expected return for Gordan = g + D(1-t)

where               g = growth rate for gordan

                         D = dividend yield,                t = tax rate

The after-tax return for both the stocks are equal.

g + 7(1 - 0.35) = 18

       g = 13.45 %

Pretax required return on gordan stock = g + D = 13.45 + 7 = 20.45%

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