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Stock Price- Dividends, Taxes, Capital Gain

Dividends and Taxes:

Investors require an after-tax rate of return of 10 percent on their stock investments. Assume that the tax rate on dividends is 30 percent while capital gains escape taxation.
A firm will pay a $2 per share dividend 1 year from now, after which it is expected to sell at a price of $20.

a. Find the current price of the stock.
b. Find the expected before-tax rate of return for a 1-year holding period.
c. Now suppose that the dividend will be $3 per share. If the expected after-tax rate of return is still 10 percent, and investors still expect the stock to sell at $20 in 1 year, at what price must the stock now sell?
d. What is the before-tax rate of return? Why is it now higher than in part (b)?

Solution Preview

Investors require an after-tax rate of return of 10 percent on their stock investments. Assume that the tax rate on dividends is 30 percent while capital gains escape taxation.

A firm will pay a $2 per share dividend 1 year from now, after which it is expected to sell at a price of $20.

a. Find the current price of the stock.

Let the current price be Po
Capital gains= $20-Po
Dividends= $2.00
Tax on capital gains= 0%
Tax on dividends= 30%

Thus after tax returns= ($20-Po) + (1-0.3)x $2= ($20-Po) + $ 1.40=
The investors demand 10% return on their stock investment
Therefore 10% x Po = ($20-Po) + $ 1.40
or 1.1 Po = $ 21.40
or Po= $21.40 / 1.1 = $19.45
Answer: Current stock ...

Solution Summary

The solution calculates the stock price and expected before-tax rate of return for a 1-year holding period

$2.19