Expected Return, Dividends and Taxes.

A. The Gecko Company and the Gordon Company is two firms whose business risk is
the same but that have different dividend policies. Gecko pays no dividend, whereas
Gordon has an expected dividend yield of 5 percent. Suppose the capital gains tax
rate is zero, whereas the income tax rate is 35 percent. Gecko has an expected
earnings growth rate of 15 percent annually, and its stock price is expected to grow
at the same rate. If the after-tax expected returns on the two stocks are equal
(because they are in the same risk class), what is the pretax required return on
Gordons stock

Ans: Gecko = Expected Earnings growth rate = 15% annually

As there are no Capital gains tax, thus after Tax returns = Pretax returns = 15%
Expected Dividend yield of Gordon = 5%
After tax returns = 5(1-.35) = 3.25%
Assuming the pay out ratio = 100%
Gordons required pretax return = 15/ (1-.35) = 23.07%
At pretax return of 23.07% on Gordon the after tax returns on both the stocks are equal.

Exchange Rate Risk

B. Suppose your company imports computer motherboards from Singapore.
(Singapores currency is the dollar; symbol S$)You have just placed an order for
$30,000 motherboards at a cost to you of 229.50 Singapore dollars each. You will
pay for the shipment when it arrives in 90 days. You can sell the motherboards for
$160 each. Calculate your profit if the exchange rate goes up or down by 10% over
the next 90 days. What is the break-even exchange rate? What percentage rise or
fall does this represent in terms of the Singapore versus the U.S. dollar?

Ans: Assumption**, 1S$ = 0.645$ on the date of purchase

Selling price for each mother board = $160
Purchase price is

= S$229.5

Purchases made for

= $30000

Purchase price of each mother board = S$229.5

No. of pieces = 30000/0.645/229.5
= S$46512/229.5
= 203
Total sales Price = $160*203
= $32480
If the exchange rate goes up by 10%,

1S$ = 0.7095$,
S$46512 = 46512*0.7095
= $33000
Profit = $32480- $33000
= Loss of $520
If the exchange rate goes down by 10%,
1S$ = 0.581S$,
S$46512 = 46512*0.581 = $27023
Profit = $32480- $27023 = $5457
Break Even Exchange rate: At Break Even there is no profit, no loss i.e. cost = Income
Sales = Income

= $32480

Therefore at break even S$46512 = $32480

Exchange rate =$32480/ S$46512= 0.6983
At Exchange Rate 1S$ = $0.6983, there is Break Even.
Percentage Rise or fall in Singapore Vs U.S. Dollar
The percentage rise = (0.6983 0.645)/0.645*100 = 8.26%
At Break Even the Exchange rate goes up by 8.26%

** [Exchange Rate is assumed from Fundamentals of corporate finance

By Ross, Stephen A. Ross, Randolph Westerfield, Bradford D. Jordan ]