Question

Suppose that Firm D and Firm G both generate the same after‐tax return of 20%. Shares of firm G currently trade at $10 per share. Firm G does not pay a dividend. Firm D pays a dividend of $1.50 per share in one year. Both firms are identical except for their payout policies. Capital gains are taxed at 15%, and dividends are taxed at 25%. Assume that you can apply capital losses against future capital gains. ​

a) Calculate the price of firm G in one year. Explain your reasoning.

b) Calculate the before‐tax and after‐tax dollar return to owning firm G for one year.

c) Calculate the before‐tax and after‐tax percentage return to owning firm G for one year.

d) Calculate the price of firm D in one year.

e) Calculate the price of firm D today.

f) Calculate the before‐tax and after‐tax dollar return to owning firm D for one year.

g) Calculate the before‐tax and after‐tax percentage return to owning firm D for one year.

Answer 1

a. Price of firm G in one year = $11.7

Current market price of share = $10, as no dividend has been paid during the year Return for the year = $2 i.e., $10*20% ( Assuming current share trading price as Share value).

As no dividend is paid, Firm G is not liable to pay any dividend tax, as there is growth in the share value capital gain need to be paid, Capital gain Tax = $2 * 15% = 0.3

Share appreciation after Capital Gain tax = $2 - $0.3 = $1.7.

Future market price of share = $10 + $1.7 = $1.7 (ignoring indexation effect).

b. For Firm G

befor tax tax return = $2.

After tax return = $ 1.7 (reducing Capital gain tax as explained above)

c. For Firm G in percentage

Before tax return = $2/$10 = 20%

After tax return = $1.7/$10 = 17%

d. Given Firm G and D are identical, taking current price of G for D = $10

Return = $10 * 20% = $2

Dividend paid = $1.5

Dividend tax = $1.5 * 25% = $0.375

Capital Gain = $2 - $1.5 = $0.5

Capital Gain tax = $0.5 * 15% = $0.075

Total Tax = $0.375 + $0.075 = $0.45

share price after date = $10 + ($2 - $0.45) = $11.55

e. Firm D price = $10

f. For Firm D

befor tax return = $2

After tax return = $1.55

g. For firm D in percxentage

befor tax return = $2/$10 = 20%

after tax return = $1.55/$10 = 15%