problem 1

Following table presents pre-tax dollar return on three stocks between dividends and capital gain. Each stock is priced at $200.

Part A: What are the expected net returns on each stock to follow three categories of investors? Current tax law suggests that capital gain tax is applied on the 50% of capital gains.

Pension Fund: It does not pay tax on either capital gain or dividend income.

Canadian Provincial Corporation: It does not may tax on intercompany dividend income. But, it pays tax at a combined federal and provincial rate of 24 percent.

Individual investor: Pays a federal marginal tax rate of 30 percent and a provincial marginal tax rate of 15 percent.

The gross-up for dividend tax credits is 20 percent. The federal dividend tax credit is 12 percent of the grossed-up dividend, and the provincial dividend tax credit is 5 percent of grossed-up dividend. There is no grossing-up for capital gain tax.

Part B: Which stock will give best return to each investor?

Part C:

Suppose, next year following changes take place with respect to dividend tax credit.

Individual investor pays a federal marginal tax rate of 22 percent and a provincial marginal tax rate of 11 percent.

The gross-up for dividend tax credits is 20 percent. The federal dividend tax credit is 15 percent of the grossed-up dividend, and the provincial dividend tax credit is 7 percent of grossed-up dividend. There is no grossing-up for capital gain tax.

Under the new tax environment, which stock will give best return to each investor? (Show calculation)

Expected Capital Gain ($) Expected Dividend ($) 20 Stock ABC Stock XYZ Stock LMN 15 15