Question

The expected pretax return on three stocks is divided between dividends and capital gains in the following way:

Stock Expected Dividend Expected Capital Gain

Stock	Expected Dividend	expected capital gain
a	0	10
b	5	5
c	10	0

A $0 $10 B 5 5 C 10 0

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.)

Answer 1

a. Calculating the net expected return on each stock for each of the investors as follows:

[Dividend (1-tax rate) +Capital Gains(1-tax rate) ]/100

Stock	Pension	Investor Corporation	Individual
A	10%	5.50%	9.50%
B	10%	7.23%	9.25%
C	10%	8.95%	9%

Working for Pension
A	($0+$10)/100 =	10/100 = 10%
B	($5+$5)/100 =	10/100 = 10%
C	($10+$0)/100 =	10/100 = 10%

Working for Corporation
A	($0(1-10.5%)+$10(1-45%)/100 =	(0+5.5)/100 = 5.5%
B	($5(1-10.5%)+$5(1-45%)/100 =	(4.475+2.75)/100 = 7.225%
C	($10(1-10.5%)+$0(1-45%)/100=	8.95+0/100 = 8.95%

Working for Individual
A	($0(1-10%)+$10(1-5%)/100 =	(0+9.5)/100 = 9.5%
B	($5(1-10%)+$5(1-5%)/100 =	(4.5+4.75)/100 = 9.25%
C	($10(1-10%)+$0(1-5%)/100=	9+0/100 = 9%

(b)

Stock	Price
A	10
B	25
C	40

Workings
	A	B	C
Expected Dividends	0	$5	10
Tax on Dividend	40%	40%	40%
After Tax Dividend Income	$0	$2	$4
Expected Capital Gain	10	5	0
Tax on Capital Gains	10%	10%	10%
After Tax Capital gain Income	$1	$0.50	0
Total After Tax Income	1	2.5	4	(After Tax Dividend income+After tax capital gain income)
After Tax yield return rate	10%	10%	10%
Stock Price	10	25	40	(After tax income/after tax yield return)