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
A	$0	$10
B	5	5
C	10	0

Required:

a. If each stock is priced at $200, 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 21% (the effective tax rate on dividends received by corporations is 6.3%), and (iii) an individual with an effective tax rate of 15% on dividends and 10% on capital gains?

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.

Answer 1

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