Assume that the shareholders of a firm pay a net tax of 30 percent on cash dividends received. After-tax earnings have been constant at $10 per share. The firm pays out all earnings in dividends at the end of each year. The market requires a 15 percent rate of return, which implies that shareholders require an after-tax return of (1 − 0.3) × 0.15 = 10.5%.
a. Calculate the share price if the firm pays out all earnings as dividends.
b. Calculate the share price if the firm retains the current year earnings and reinvests it at 15 percent. Starting next year, the firm reverts to a zero retention policy. What is the capital gain? Do shareholders prefer dividends or capital gains?