Consider two corporations, G and H, that have exactly the same risk. They both have a current stock price of $60. Corporation G pays no dividend and will have a price of $66 one year from now. Corporation H pays dividends and will have a price of $63 one year from now after payment of a dividend. Corporations pay no income taxes. Investors pay no taxes on capital gains, but they pay a 30% income tax on dividends. What is the value of the dividend that investors expect Corporation G to pay?

Question

Quizplus · Accepted Answer

Given that both corporations have the same risk and investors are indifferent between investing in either corporation, the after-tax return must be the same for both. Corporation G's stock price will increase from $60 to $66, a gain of $6. To find the equivalent after-tax return for Corporation H, we need to account for the dividend and the increase in stock price from $60 to $63. Let D be the dividend paid by Corporation H. The after-tax value of the dividend is D*(1-0.30) = 0.7D. The total after-tax return for an investor in Corporation H is $3 (from the increase in stock price) + 0.7D (the after-tax value of the dividend). This total return should equal the $6 gain from Corporation G for the investments to be equivalent. Therefore, $3 + 0.7D = $6, solving for D gives D = $4.29.

Consider Two Corporations, G and H, That Have Exactly the Same