An investor has a 38 percent ordinary income tax rate and a 20 percent long-term

Question

An investor has a 38 percent ordinary income tax rate and a 20 percent long-term capital gains tax rate. The investor holds stock in a firm that could pay its usual $1 per share dividend or reinvest the cash in the firm. The stock price is currently $30 per share. If the firm does not pay the dividend, the share price will rise. If it pays the dividend, the share price will stay the same. By how much must the share price rise if the dividend is not paid in order to make the investor indifferent between receiving the dividend or not?

$0.97

$1.00

$0.78

$0.50

$0.59

Explanation / Answer

If the investor would have received the dividend, tax on each dollar received =$0.38

Hence, net realization =$1.00-0.38 =$0.62

On the other hand if the company doesnt pay dividend and rather keeps the retained earnings, the gain in share price will be subjected to 20% capital gains tax. Let P be the new share price.

=> Net Realization =(1-0.20)x(P-30)

Since, the value of net realization has to be same in both cases,

(1-0.20)x(P-30) = 0.62

0.80 x (P-30) =0.62

P-30 = 0.775

P = 30.775

Share Price increase =$0.775 or $0.78

Hence, option-(c) is the right answer

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