Question

Kahn Inc. has a target capital structure of 65% common equity and 35% debt to fund its $8 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 12%, a before-tax cost of debt of 11%, 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 $29.

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 $1.3 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

Answer of Part a:

Before Cost of Debt = 11%
WACC = 12%
Weight of Debt = 0.35
Weight of Equity = 0.65

WACC = Weight of Debt * Before Cost of Debt * (1 – tax rate) + Weight of Equity * Cost of Equity
0.12 = 0.35 * 0.11 * (1-0.25) + 0.65 * Cost of Equity
0.12 = 0.0289 + 0.65 * Cost of Equity
0.12 – 0.0289 = 0.65 * Cost of Equity
0.0911 = 0.65 * Cost of Equity
Cost of Equity = 0.0911 / 0.65
Cost of Equity = 0.1402 or 14.02%

Expected Dividend, D1 = $2
Current Stock Price, P0 = $29

Cost of Equity = D1 / P0 + g
0.1402 = $2 / $29 + g
0.1402 = 0.0690 + g
g = 0.1402 – 0.0690
g = 0.0712 or 7.12%

Answer of Part b:

Net Income = $1,300,000,000

Common Equity = $8,000,000,000 * 65%
Common Equity = $5,200,000,000

Return on Equity = Net Income / Common Equity
Return of Equity = $1,300,000,000 / $5,200,000,000
Return of Equity = 0.25 or 25%

Growth Rate = (1 – Payout Ratio) * ROE
0.0712 = (1 – Payout Ratio) * 0.25
0.0712 / 0.25 = (1 – Payout ratio)
0.2848 = 1 – Payout Ratio
Payout Ratio = 1-0.2848
Payout Ratio = 0.7152 or 71.52%