Question

1. A project has annual cash flows of $7,500 for the next 10 years and then $5,500 each year for the following 10 years. The IRR of this 20-year project is 12.08%. If the firm's WACC is 11%, what is the project's NPV? Do not round intermediate calculations. Round your answer to the nearest cent.

2. Kahn Inc. has a target capital structure of 55% common equity and 45% debt to fund its $11 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 13%, a before-tax cost of debt of 10%, 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 $27.

1. What is the company's expected growth rate? Do not round intermediate calculations. Round your answer to two decimal places.

     %

2. If the firm's net income is expected to be $1.2 billion, what portion of its net income is the firm expected to pay out as dividends? Do not round intermediate calculations. Round your answer to two decimal places. (Hint: Refer to Equation below.)

   Growth rate = (1 - Payout ratio)ROE

Answer 1

Solution:

1) The concept used in the solution is IRR and NPV approach.

a) Concepts

> NPV - Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.

> IRR - The internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.

b) Formula

> NPV = Present value of cash inflow (PVCI) - Present value of cash outflow (PVCO)

> IRR, where PVCI -PVCO = 0

                     i.e. at IRR, PVCO = PVCI

c) Calculation

At IRR PVCO = PVCI

Thus PVCO = 7500 * PVAF (12.08%, 10) + 5500 * PVAF (12.08%, 10) * PVIF (12.08%, 10)

                      = 7500 * 5.6318 + 5500 * 5.6318 * 0.3197

                      = $ 52141.18 (Approx)

Thus PVCO = 52141.18

- NPV Calculation

PVCI @ 11% = 7500 * PVAF (10%, 10) + 5500 * PVAF (10%, 10) * PVIF (10%, 10)

                      = 7500 * 6.1446 + 5500 * 6.1446 * 0.3855

                      = 59112.59

NPV = 59112.59 - 52141.18

        = $ 6971.41 Answer

2) Solution

WACC = weighted average cost

=> 13 = 55% * Cost of equity + 45% * 7.5%

=> Cost of equity or Expected returns= 17.50%

Expected return = [D1 / P0 ]+ g

=> 0.175 = [2/27] + g

=> g = 10.09 %

- Given

g = (1 - Payout ratio)ROE

10.09 = (1 - Payout ratio) * 17.5

Payout ratio = 0.42

Expected payout = 1.2 Billion * .42

                            = 0.51 billion

Hope you understand the solution.