Question

Kahn Inc. has a target capital structure of 45% common equity and 55% debt to fund its $12 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 16%, a before-tax cost of debt of 9%, 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 $3, 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.

     %

2. If the firm's net income is expected to be $1.6 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 = 9%
WACC = 16%
Weight of Debt = 0.55
Weight of Equity = 0.45

WACC = Weight of Debt * Before Cost of Debt * (1 – tax rate) + Weight of Equity * Cost of Equity
0.16 = 0.55 * 0.09 * (1-0.25) + 0.45 * Cost of Equity
0.16 = 0.0371 + 0.45 * Cost of Equity
0.16 – 0.0371 = 0.45 * Cost of Equity
0.1229 = 0.45 * Cost of Equity
Cost of Equity = 0.1229 / 0.45
Cost of Equity = 0.2731 or 27.31%

Expected Dividend, D1 = $3
Current Stock Price, P0 = $25

Cost of Equity = D1 / P0 + g
0.2731 = $3 / $25 + g
0.2731 = 0.12 + g
g = 0.2731 – 0.12
g = 0.1531 or 15.31%

Answer of Part b:

Net Income = $1,600,000,000

Common Equity = $12,000,000,000 * 45%
Common Equity = $5,400,000,000

Return on Equity = Net Income / Common Equity
Return of Equity = $1,600,000,000 / $5,400,000,000
Return of Equity = 0.2963 or 29.63%

Growth Rate = (1 – Payout Ratio) * ROE
0.1531 = (1 – Payout Ratio) * 0.2963
0.1531 / 0.2963 = (1 – Payout ratio)
0.5167 = 1 – Payout Ratio
Payout Ratio = 1-0.5167
Payout Ratio = 0.4833 or 48.33%