Task: 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)?