have different dividend policies. Gecko pays no dividend, whereas Gordon has an

Question

have different dividend policies. Gecko pays no dividend, whereas Gordon has an expected dividend yield of 4 percent. Suppose the capital gains tax rate is zero, whereas the income tax rate is 30 percent. Gecko has an expected earnings growth rate of 16 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? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Pretax return

Explanation / Answer

Expected earnings growth rate = 16%

Since there is no capital gains tax, Pretax return = 16%

Expected Dividend yield = 4%

After tax returns = g + D*(1-t) = 16%

16% = g + 0.04*(1-0.3)

g = 0.132 = 13.20%

Pretax return = g + D

Pretax return = 0.1320 + 0.04 = 0.1720 = 17.20%

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