Assume that the tax rate on capital gains is 15%, while the tx rate on dividend
ID: 2815170 • Letter: A
Question
Assume that the tax rate on capital gains is 15%, while the tx rate on dividend in come is 20%. An investor is comparing two options for the stock of ABC firm: 1) receive $100 of dividend income now. II) get unrealized capital gains of $100 now which are left to grow with the firm for five years. The expected rate if return on the stock of ABC firm is 8. The investor will invest his after-tax-dividend income in ABC's stock for five years. How much higher after-tax income the investor will get in five years under the capital gains option II than under the devidend income option I (i.e., difference of option II income over option I income)?
Explanation / Answer
Option 1: Dividend Option
146.9328( 1 - 0.15) = 124.8929
Solution:Option 1: Dividend Option
When we receive our dividend of $ 100 will pay a tax of $20 on it. So net available for investment for 5 years = $ 80 Now this $80 is reinvested in ABC stock providing 8% return for 5 years. Let us calculate what will be that value .... 80 ( 1.08)5 = 117.55 $80 which is already tax and being investment will not be taxed again. So taxable part of additional income will be 117.55 - 80 = 37.55 So total after tax income after 5 years will be 85 + 37.55(1 - 0.15) = 85 + 31.9175 = 116.9175 :- After 5 years additional income earned on dividend income will be capital gain, So tax rate would be 15% Option II: Capital Gain Option Since it is unrealised capital gain, tax does not become immediatly due now. so $100 will be invested for 5 years by the firm itself @ 8%. such amount after 5 years shall be 100(1.08)5 = 146.9328 As there is no taxation earlier, total of the income received after 5 years shall be subjected tax @ 15%146.9328( 1 - 0.15) = 124.8929
Investor will get higher under option II i.e. Capital Gain Option over the Option I i.e. Dividend Option $124.8929 - $116.9175 = $7.9754