Question

A given share is sold for $30 just before time t0. If the firm pays a $3 dividend per share, the price will immediately drop to $27. Suppose you own 100 shares. If the firm decides not to distribute dividends, you would need to sell 10 shares (at$30 a share) since you need to have a $300 cash income (pre tax) Assume that the shares were originally bought for $20 each.

1. If both ordinary personal tax rate and capital gains tax are 28%, what is your after-tax wealth under the two alternative situations?

2. Suppose now the tax rates for capital gains are lower, you pay 40% tax on ordinary income, and 16% tax on capital gains. What is your after-tax wealth under the two alternative situations?

Answer 1

Shares bought at $20 each. when both the tax rates are 28%

part 1) Share price = 30; Lets assume no dividends; you sell 10 shares for 300; capital gains are 300-200(they were bought for 200)

Capital gains = 100; tax = 28% ; remaining = 72; net worth = 272 + 90 remaining shares that you have at 30

2700+272 = 2972

second situation;

share price = 30; company gives dividends; dividend received = 3 *100 = 300. all of this is taxable. 300*28% = 84;

remaining = 216 + 100 shares at 27 = 2700 + 216 = 2916

Part 2) 40% on ordinary income and 16% on capital gains

Share price = 30; Lets assume no dividends; you sell 10 shares for 300; capital gains are 300-200(they were bought for 200)

Capital gains = 100; tax = 16% ; remaining = 16; net worth = 284 + 90 remaining shares that you have at 30

2700+284 = 2984

second situation;

share price = 30; company gives dividends; dividend received = 3 *100 = 300. all of this is taxable. 300*40% = 120;

remaining = 180 + 100 shares at 27 = 2700 + 180 = 2880

Let me know if you have any doubts.