Question

Cash As Cash Can (CACC) Corp. and Internal Items Inc. (III) 20are in the same risk class. Shareholders expect CACC to pay a USD 5 dividend next year (D1) at which time the stock will sell at an ex-dividend price (P1) of USD 20/share. III does
not pay a dividend but III’s shareholders expect a USD 5 capital gain at the end of next year. Currently, III’s stock is selling for USD 20/share (P0). Also assume that all dividends and capital gains are realized at the end of the year. For parts (a) and (b), assume that capital gains are not taxed, but dividends are taxed at 25% personal tax rate. For parts (c) and (d), assume that both capital gains and dividends are taxed at a 25% personal tax rate.

1. (a) What is the expected return on III’s stock?

2. (b) What is the current price (P0) of CACC’s stock?

3. (c) With the changed assumption on capital gains and dividend taxation recalculate the expected return on III’s stock in one year under these new assumptions. (Hint: Assume the marginal investor sells the stock.)

4. (d) What happens to the price of CACC’s stock? (Be explicit.) Why?

Answer 1

Solution:-

(a)

Current price (III)= $20 per share

Expected price after one year= current price + expected capital gains= $20 + $5 = $25 per share

Expected return (III)= ($25-$20)/$20= 25%

(b)

Expected ex-dividend price after one year (CACC)= $20

Expected dividend for next year after tax= $5*(1-25%)= $3.75 per share

Expected price after one year before getting ex-dividend= $20 + $3.75= $23.75

The current share price is equal to the ex-dividend price after one year:

Explanation:

Since the company pays out its earnings as dividends, the increase in share price for the year will be equal to the accrual of expected post tax dividends for the year. In other words, the current share price will increase over the course of next year by $3.75, i.e. expected dividend income post tax. The current share price is equal to expected ex dividend price after one year

Current share price (CACC)= $23.75-$3.75= $20 per share

(c)

Current price (III)= $20 per share

Expected price after one year= current price + expected capital gains= $20 + $5 = $25 per share

Expected return in $ (III)= ($25-$20)*(1-tax rate)= ($25-$20)*(1-25%) = $3.75 per share

Expected return in % (III)= $3.75/$20= 18.75%

(d)

The change in taxation doesn't bring anhy change to the ex-dividend price of CACC after one year (i.e. $20). Since, the current stock price is equal to the ex-dividend price after one year, there will be no change in the price of CACC's stock due to change in taxation assumptions.