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 35% (the effective tax rate on dividends received by corporations is 10.5%), and (iii) an individual with an effective tax rate of 15% on dividends and 10% on capital gains? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.)

b. Suppose that investors pay 50% tax on dividends and 20% tax on capital gains. If stocks are priced to yield an after-tax return of 8%, 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.)

Explanation / Answer

a.(i) a pension fund that does not pay taxes

Stock A = 14/100 = 14.00%

Stock B = (9+9)/100 =18.00%

Stock C =14/100 = 14.00%

(ii) a corporation paying tax at 35% (the effective tax rate on dividends received by corporations is 10.5%), and

Stock A = (0+14*(1-0.35))/100 = 9.10%

Stock B = (9*(1-0.105)+9*(1-0.35))/100 = 13.905% =13.91%

Stock C = (14*(1-0.105) +0)/100 = 12.53%

(iii)an individual with an effective tax rate of 15% on dividends and 10% on capital gains

Stock A = (0 +14*(1-0.10))/100 = 12.60%

Stock B = (9*(1-0.15) +9*(1-0.10))/100 = 15.75%

Stock C = (14*(1-0.15) +0)/100 = 11.90%

(b) Price of Stock = (Dividend*(1-0.5) + Capital Gain*(1-0.2))/0.08

Stock A = (0*0.5+14*0.8)/0.08 = $140.00

Stock A = (9*0.5+9*0.8)/0.08 = $146.25

Stock A = (14*0.5+0*0.8)/0.08 = $87.50

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