Question

Kahn Inc. has a target capital structure of 50% common equity and 50% debt to fund its $8 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 15%, 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 $3, and the current stock price is $32.

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

%

b) If the firm's net income is expected to be $1.1 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

A) Expected Growth Rate = 12.375%

B) Dividend Payout Ratio = 55%

Solution:

WACC = 15%

Before Tax Cost of Debt (R_d) = 11%

Tax Rate (T) = 25%

Expected Dividend (D₁)= $3

Current Stock Price (P₀) = $32

Target Capital Structure = 50% Equity and 50% Debt

Answer A) Expected Growth Rate: To find growth rate first find cost of equity from WACC

WACC = W_dR_d(1-T)+ W_eR_e

15% = (50%)(11%)(1-25%)+(50%)R_e

15% = 4.125%+0.5R_e

0.5R_e = 15%-4.125% = 10.875%

R_e = 10.975%/0.5 = 21.75%

Now that we know R_e (Cost of Equity) we can calculate Growth Rate using Dividend Discount Model

g = R_e - (D₁/P₀)

= 21.75% - ($3/$32)

= 21.75% - 9.375%

= 12.375%

Answer B

Dividend Payout Ratio: g = (Net Income/Common Equity) (1-Dividend Payout Ratio)

Net Income/ Common Equity = ROE (Return on Equity)

g = (Net Income/Common Equity) (1-Dividend Payout Ratio)

12.375% = ($1,100,000,000 / ($8,000,000,000 x 50%))(1-Dividend Payout Ratio)

12.375% = ($1,100,000,000 / ($4,000,000,000)(1-Dividend Payout Ratio)

12.375% = 27.50% (1-Dividend Payout Ratio)

(12.375%)/(27.50%) = (1-Dividend Payout Ratio)

45% =  (1-Dividend Payout Ratio)

Dividend Payout Ratio = 55%