As discussed in the text, in the absence of market imperfections and tax effects

Question

As discussed in the text, in the absence of market imperfections and tax effects, we would expect the share price to decline by the amount of the dividend payment when the stock goes ex dividend. Once we consider the role of taxes, however, this is not necessarily true. One model has been proposed that incorporates tax effects into determining the ex-dividend price:1

where P0 is the price just before the stock goes ex, PX is the ex-dividend share price, D is the amount of the dividend per share, TP is the relevant marginal personal tax rate on dividends, and TG is the effective marginal tax rate on capital gains.

Suppose the only owners of stock are corporations. Recall that corporations get at least a 70 percent exemption from taxation on the dividend income they receive, but they do not get such an exemption on capital gains. If the corporation’s income and capital gains tax rates are both 40 percent, what does this model predict the ex-dividend share price will be?

As discussed in the text, in the absence of market imperfections and tax effects, we would expect the share price to decline by the amount of the dividend payment when the stock goes ex dividend. Once we consider the role of taxes, however, this is not necessarily true. One model has been proposed that incorporates tax effects into determining the ex-dividend price:1

Explanation / Answer

Tp=40%, Tg=40%
    P0 - Px = D(1-Tp)/(1-Tg)

    ex. dividend price = Previous price - decrease in price

     at least 70% of dividend income will be exempt, only 30% would be taxed. effectively the tax rate on dividend would be 0.40*0.30 = 0.12%

     D * (1 - 0.0012)/(1-0.40) = 1.664D is the decrease

ex-dividend price = P0 - 1.664D

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