Question

Kahn Inc. has a target capital structure of 65% common equity and 35% debt to fund its $11 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 15%, a before-tax cost of debt of 12%, and a tax rate of 25%. The company's retained earnings are adequate to provide the common equity portion of its capital budget. Its expected dividend next year (D₁) is $2, and the current stock price is $32.

a. What is the company's expected growth rate?

b. If the firm's net income is expected to be $1.7 billion, what portion of its net income is the firm expected to pay out as dividends?

Answer 1

a.
Using the dividend growth model we would calculate the growth rate
Growth rate (g)	Ke - D1/P0
Ke is cost of equity
D1 is expected dividend
P0 is share price today
Using the WACC formula we would calculate cost of equity
WACC	Wd*Kd*(1-tax rate) + We*Ke
Wd is weight of debt, Kd is cost of debt, We is weight of equity, Ke is cost of equity
15%	(0.35*12%*(1-0.25))+(0.65Ke)
15%	0.0315 + 0.65Ke
Ke	(0.15-0.0315)/0.65
Ke	0.1185/0.65
Ke	18.23%
Growth rate (g)	18.23% - (2/32)
Growth rate (g)	18.23% - 0.0625
Growth rate (g)	11.98%
Thus, growth rate is 11.98%
b.
Calculate payout ratio
Growth rate	(1-Payout ratio)*ROE
Growth rate	(1-Payout ratio)*(Net income/Common equity)
11.98%	(1-Payout ratio)*(1.7 billion/($11 billion*65%))
11.98%	(1-Payout ratio)*(1.7 billion/7.15 billion)
11.98%	(1-Payout ratio)*0.237762
1-Payout ratio	11.98%/0.237762
1-Payout ratio	0.503865
Payout ratio	1-0.503865
Payout ratio	49.61%
Thus, 49.61% of its net income would be distributed as dividend