Question

ANALYTICAL THINKING AND CONCEPT INTEGRATION: Kahn Inc. (KI) is a distributor of intellectual property. Suppose that you are a member of the financial analyst team at Edward Jones Investments (EJI) and have ascertained the following about KI as of June 15, 2018:

KI’s management desires to maintain a target capital structure of 60% common equity and 40% debt to fund its $10 billion in operating assets.

KI’s WACC is 13%;

KI has a before-tax cost of debt of 10%, and a corporate tax rate of 25%;

KI’s forecast net income is expected to be $1.1 billion;

KI’s retained earnings (aka, internally generated funds) are sufficient to cover all of the equity portion of its capital budget; that is, Ki will not need to issue new common stock for any upcoming capital expenditures (CAPEX);

KI’s expected dividend next year is $3 per common share;

KI’s current stock price is $35.

TASKS: Please -

-Define a corporation’s “sustainable growth rate” and its significance to that corporation’s “capital structure” and “capital budget”;

-Calculate KI’s expected growth rate;

-Determine the portion of KI’s income that it will be expected to pay out as dividends to shareholders if it adheres to its target debt : equity ratio.

-Based on the financial information you have developed for this case scenario, forecast KI’s assets, liabilities, and shareholders’ equity for its next fiscal year ended June 15, 2019. Be sure to state assumptions and logic !

Answer 1

Soln : Sustainable Growth rate : It is defined as the multiplication of return on equity and plowback ratio.

SGR = ROE *(1-dividend payout ratio)

With this rate in picture, we can say that company is able to sufficiently producing profits and hence retained earnings to get its all requirement for CAPEX and hence decide on the capital budgetin process.

WACC = 13%, debt : equity = 4:6 on using the WACC formula we will get ROE = r

13 = 0.4*10*(1-0.25) +0.6*r or r = 16.67%

Dividend paid = $3 per share, we are considering that KI will maintain growth rate as g for dividend and profits.

Using dividend growth model , we can say:

35 = 3/(13%-g), on solving we get g = 4.43% i.e. the expected growth rate = 4.43%

Now, Using the equation of sustainable growth rate , we can calculate the payout ratio, p

4.43 = ROE *(1-p) or 4.43/16.67 = 1-p

P = 73.43% = payout ratio

Expected KI liabities = 4 *(1+4.43% )= 4.18 billion

Expected shareholders equity = 6*(1+4.43% ) = 6.27

Expecr=ted assets for year ended June 2019 = 6.27+ 4.18 = 10.45 billion