Suppose that there are just three types of investors with the following tax rates:

...

Question

Suppose that there are just three types of investors with the following tax rates:

Individuals

Corporations

Institutions

Dividends

50%

5%

0%

Capital gains

15

35

0

Individuals invest a total of $80 billion in stock and corporations invest $10 billion. The remaining stock is held by the institutions. All three groups simply seek to maximize their after-tax income.
These investors can choose from three types of stock offering the following pretax payouts:

Low Payout

Medium Payout

High Payout

Dividends

$5

$30

Capital gains

15

5

0

These payoffs are expected to persist in perpetuity. The low-payout stocks have a total market value of $100 billion, the medium-payout stocks have a value of $50 billion, and the high-payout stocks have a value of $120 billion.
a. Who are the marginal investors that determine the prices of the stocks?
b. Suppose that this marginal group of investors requires a 12% after-tax return. What are the prices of the low-, medium-, and high-payout stocks?
c. Calculate the after-tax returns of the three types of stock for each investor group.
d. What are the dollar amounts of the three types of stock held by each investor group?

David · Accepted Answer

a) The marginal investors are the institutions. They set prices on the market because they�can switch between available investments. After-tax rate of return for them must be�equal regardless which stock they buy.�To see why that must be the case, observ
a) The marginal investors are the institutions. They set prices on the market because they
can switch between available investments. After-tax rate of return for them must be
equal regardless which stock they buy.
To see why that must be the case, observe that the total value of stocks held by the
institutions is $180 billion. Then suppose that the expected rate of return for some class of
stocks is higher than 12%.

Suppose that there are just three types of investors with the following tax rates: Individuals Corporations Institutions Dividends 50% 5% 0% Capital gains 15 35 0 Individuals invest a total of $80...

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