Question

has a target capital structure of 65% common equity and 35% debt to fund its $10 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 16%, 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 $25.

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

   11.78 %

2. If the firm's net income is expected to be $1.0 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 to Part a.
Before Tax Cost of Debt = 12%
Tax Rate = 25%
After Tax Cost of Debt = 12% * (1 – 0.25)
After Tax Cost of Debt = 9%

Weight of Equity = 0.65
Weight of Debt = 35%

WACC = (Weight of Equity * Cost of Equity) + (Weight of Debt * After Tax Cost of Debt)
16% = (0.65 * Cost of Equity) + (0.35 * 9%)
16% = (0.65 * Cost of Equity) + 3.15%
12.85% = (0.65 * Cost of Equity)
Cost of Equity = 19.78%

Cost of Equity = Expected Dividend / Current Price + Growth Rate
0.1978 = $2 / $25 + Growth Rate
0.1978 = 0.0800 + Growth Rate
Growth Rate = 11.78%

Answer to Part b.
Operating Assets = $10 Billion
Value of Equity = $10 Billion * 65%
Value of Equity = $6.5 Billion

Return on Equity (ROE) = Net Income / Equity * 100
Return on Equity (ROE) = $1.0 Billion /$6.5 Billion * 100
Return on Equity (ROE) = 15.3846%

Growth Rate = (1 – Payout Ratio) ROE
0.1178 = (1 – Payout Ratio) * 0.153846
0.7657 = 1 – Payout Ratio
Payout Ratio = 0.2343 or 23.43%