a. If each stock is priced at $100, what are the expected net percentage returns

Question

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 45% (the effective tax rate on dividends received by corporations is 10.5%), and (iii) an individual with an effective tax rate of 10% on dividends and 5% on capital gains? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.)

b. Suppose that investors pay 40% tax on dividends and 10% tax on capital gains. If stocks are priced to yield an after-tax return of 10%, 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.)

Stock Expected Dividend Expected Capital Gain A $0 $10 B 5 5 C 10 0

Explanation / Answer

a).

i) Pension Fund:

Ra = ($0 + 10)/$100 = $10/$100 = 0.1000, or 10.00%

Rb = ($5 + 5)/$100 = $10/$100 = 0.1000, or 10.00%

Rc = ($10 + 0)/$100 = $10/$100 = 0.1000, or 10.00%

ii). Corporation:

Ra = [($0 × (1 – .105) + ($10 × (1 – .45)] / $100 = $5.5/$100 = 0.0550, or 5.50%

Rb = [($5 × (1 – .105) + ($5 × (1 – .45)] / $100 = $7.225/$100 = 0.0723, or 7.23%

Rc = [($10 × (1 – .105) + ($0 × (1 – .45)] / $100 = $8.95/100 = 0.0895, or 8.95%

iii). Individual:

Ra = [($0 × (1 – .10) + ($10 × (1 – .05)] / $100 = $9.5/$100 = 0.0950, or 9.50%

Rb = [($5 × (1 – .10) + ($5 × (1 – .05)] / $100 = $9.25/$100 = 0.0925, or 9.25%

Rc = [($10 × (1 – .10) + ($0 × (1 – .05)] / $100 = $9/$100 = 0.09, or 9.00%

b).

Price A = [($0 × (1 – .40) + $10.00 × (1 – .10)] / .10 = $9/0.10 = $90.00

Price B = [($5 × (1 – .40) + $5.00 × (1 – .10)] / .10 = $7.50/0.10 = $75.00

PriceC= [($10 × (1 – .40) + $0 × (1 – .10)] / .10 = $6/0.10 = $60.00

Stock Pension Investor Corporation Individual A 10% 5.50% 9.50% B 10% 7.23% 9.25% C 10% 8.95% 9.00%

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