Here is a question that has stumped me. Why is the return being calculated with a $110 stock price? Shouldn't it be $100?

Problem 17-3 Payout Policy and Taxes (LO4)

The expected pretax return on three stocks is divided between dividends and capital gains in the following way:

A: 0 dividend $10 capital gain

B: $5 dividend $5 capital gain

C: $10 dividend $0 capital gain

C

a.If each stock is priced at $100, what are the expected net percentage returns on each stock to (i) a pension fund that does not pay taxes, (ii) a corporation paying tax at 35% (the effective tax rate on dividends received by corporations is 10.5%), and (iii) an individual with an effective tax rate of 15% on dividends and 10% on capital gains?(Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.)

Answer:

Explanation:

Some values below may show as rounded for display purposes, though unrounded numbers should be used for actual calculations.

a.

(i) Pension fund:

r_A= ($0 + 10) / $110 = 0.0909, or 9.09%

r_B= ($5 + 5) / $110 = 0.0909, or 9.09%

r_C= ($10 + 0) / $110 = 0.0909, or 9.09%

(ii) Corporation:

r_A= [($0 (1 - 0.105) + ($10 (1 - 0.35)] / $110 = 0.0591, or 5.91%

r_B= [($5 (1 - 0.105) + ($5 (1 - 0.35)] / $110 = 0.0702, or 7.02%

r_C= [($10 (1 - 0.105) + ($0 (1 - 0.35)] / $110 = 0.0814, or 8.14%

(iii) Individual:

r_A= [($0 (1 - 0.15) + ($10 (1 - 0.10)] / $110 = 0.0818, or 8.18%

r_B= [($5 (1 - 0.15) + ($5 (1 - 0.10)] / $110 = 0.0795, or 7.95%

r_C= [($10 (1 - 0.15) + ($0 (1 - 0.10)] / $110 = 0.0773, or 7.73%