Question

WACC AND COST OF COMMON EQUITY

Kahn Inc. has a target capital structure of 55% common equity and 45% debt to fund its $10 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 15%, a before-tax cost of debt of 10%, and a tax rate of 40%. The company's retained earnings are adequate to provide the common equity portion of its capital budget. Its expected dividend next year (D₁) is $4, and the current stock price is $28.

What is the company's expected growth rate? Round your answer to two decimal places at the end of the calculations. Do not round your intermediate calculations.
____%

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? (Hint: Refer to Equation below.)

Growth rate = (1 - Payout ratio)ROE

Round your answer to two decimal places at the end of the calculations. Do not round your intermediate calculations.
____%

Answer 1

Answer a.

Before-tax Cost of Debt, rd = 10%
tax rate, t = 40%
Weight of Debt, wd = 45%
Weight of Common Equity, ws = 55%

Let Cost of Equity be rs

WACC = wd*rd*(1-t) + ws*rs
15% = 45%*10%*(1-0.40) + 55%*rs
15% = 2.70% + 55%*rs
12.30% = 55%*rs
rs = 22.36%

Cost of Equity = 22.36%

Let growth rate be g

Cost of Equity = D1 / P0 + g
22.36% = $4 / $28 + g
0.2236 = 0.1429 + g
0.0807 = g
g = 8.07%

So, expected growth rate is 8.07%

Answer b.

Operating Assets = $10 billion

Value of Equity = 55% * $10 billion
Value of Equity = $5.50 billion

ROE = Net Income / Value of Equity
ROE = $1.1 billion / $5.5 billion
ROE = 0.20

Growth Rate = (1 - Payout Ratio) * ROE
0.0807 = (1 - Payout Ratio) * 0.20
0.4035 = 1 - Payout Ratio
Payout Ratio = 0.5965
Payout Ratio = 59.65%