Question: Company A and B have time zero EBIT of $1,000. The required return on equity for both of these unlevered companies is 10%. The marginal corporate tax rate is 34 percent. Company C has a dividend payout ratio of 20% & a dividend growth rate of 8 percent. Company D has a dividend payout ratio of 80% & a dividend growth rate of 4%.
Note that in order for dividends to grow at a constant price, given a fixed dividend payout ratio, EBIT must also grow at the similar rate. Consequently, the EBIT increase rate must equal the dividend increase rate for each firm. Compute the after tax rate of return on each company reinvestment of earnings.
Δ [EBIT (1 - Tc]/REo