Suppose that taxable bonds maturing in 5 years yield 10% per year before tax.
a. What risk adjusted appreciation rate on a non dividend paying common stock is required for the following taxpayers to be indifferent between investing in bonds and stock for 5 years:
1. Taxpayers paying a 30% tax rate on taxable bond interest and a 30% tax rate on capital gains when realized.
2. Taxpayers paying a 30% tax rate on taxable bond interest and a 50/ 50 chance (the outcome being independent of the stock return) of a 20% and a 30% tax rate on capital gains when realized.
b. If the taxpayer in (a.2.) were the marginal investor setting prices in the marketplace, what would be the implicit tax rate on the returns to stock?
c. If the taxpayer in (a.2.) were the marginal investor setting prices in the marketplace, what arbitrage strategies would be available in a frictionless setting to the following investors:
1. A tax exempt entity;
2. An individual taxpayer who can deduct interest expense on borrowing and who faces a 40% tax rate on ordinary income and a 30% tax rate on capital gains and losses;
3. An individual taxpayer who can deduct interest expense on borrowing and who faces a 40% tax rate on both ordinary income and capital gains and a 30% tax rate on capital losses.
d. Suppose we have an investor who faces a 30% tax rate on dividends and an expected tax rate of 20% on capital gains when they are realized 5 years from now. If a stock pays an annual dividend at the end of each year equal to 5% of the stock price at the beginning of the year, what appreciation rate on the stock is required to enable a 7% after tax return per year over a 5 year period?
e. What would be the implicit tax rate on the returns to the stock in (d)?