Question

Assume you purchased the stock of Del Mar Spa at $35 per share one year ago, its current price is $42. Sitting on an enviable huge cash coffer, Del Mar Spa is considering three alternatives of paying dividend to its shareholders. Choices #1 and #2 are to pay a dividend of $2 and $3 respectively. Choice #3 is paying nothing. Further assume that the price drop on ex date will be equal to the dividend per share. Your income tax on dividend income is 28%, and 20% on capital gain. Which choice would you prefer? Compare the after-tax capital gain and dividend income among three choices!

Answer 1

We will analyze three choices individually

Choice 1

Price one year ago = $35, Current price = $42 , Dividend income = $2, Tax on dividend income = 28% and capital gain tax rate = 20%

Price after dividend distribution = Current price - dividend income = 42 - 2 = 40

After tax capital gain = (Price after dividend distribution - price one year ago)(1- capital gain tax rate) = (40-35)(1-20%) = 5 x 80% = $4

After tax dividend income = Dividend income (1 - Tax rate on dividend income) = 2 (1 - 28%) = 2 x 72% = $1.44

Total after tax return = [(After tax capital gain + after tax dividend income) / Price one year ago] = [(4 + 1.44) / 35] = (5.44/35) = 15.54%

Choice 2

Price one year ago = $35, Current price = $42 , Dividend income = $3, Tax on dividend income = 28% and capital gain tax rate = 20%

Price after dividend distribution = Current price - dividend income = 42 - 3 = 39

After tax capital gain = (Price after dividend distribution - price one year ago)(1- capital gain tax rate) = (39-35)(1-20%) = 4 x 80% = $3.2

After tax dividend income = Dividend income (1 - Tax rate on dividend income) = 3 (1 - 28%) = 3 x 72% = $2.16

Total after tax return = [(After tax capital gain + after tax dividend income) / Price one year ago] = [(3.2 + 2.16) / 35] = (5.36/35) = 15.31%

Choice 3

Price one year ago = $35, Current price = $42 , Dividend income = $0, Tax on dividend income = 28% and capital gain tax rate = 20%

Since there is no dividend income hence total after return will only consist of after tax capital gain and there will no change in current price

After tax capital gain = (Current price - price one year ago)(1- capital gain tax rate) = (42-35)(1-20%) = 7 x 80% = $5.60

Total after tax return = After tax capital gain / Price one year ago = 5.60 / 35 = 16.00%

On the basis on after tax capital gain and dividend income Choice 3 offers highest return, therefore we would prefer choice 3.