Two corporations A and B have exactly the same risk and both have a current stock price of $100. Corporation A pays no dividend and will have a price of $120 one year from now. Corporation B pays dividends and will have price of $113 one year from now after paying the dividend. The corporations pay no taxes and investors pay no taxes on capital gains but pay a tax of 30% income tax on dividends. What is the value of the dividend that investors expect corporation B to pay one year from today?
A) $7
B) $13
C) $10
D) None of the above

Question

Quizplus · Accepted Answer

The expected return for both corporations should be the same due to identical risk. Corporation A's return is $20 ($120 - $100). For Corporation B, the after-tax dividend plus the price increase ($113 - $100) should equal $20. Let D be the dividend; after-tax dividend is 0.7D. So, 0.7D + $13 = $20, solving gives D = $10.

Two Corporations a and B Have Exactly the Same Risk