Question

Kahn Inc. has a target capital structure of 60% common equity and 40% debt to fund its $10 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 16%, a before-tax cost of debt of 10%, 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 $34.

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

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2. If the firm's net income is expected to be $1.2 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

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Answer 1

Part(a)

Calculating Cost of Equity from WACC:-

WACC= (Weight of Debt)(Cost of Debt)(1-Tax Rate) + (Weight of Equity)(Cost of Equity)

16% = (0.40)(10%)(1-0.25) + (0.60)(Cost of Equity)

16% - 3% = (0.60)(Cost of Equity)

Cost of Equity = 21.6666%

Now calculating Expected Growth rate using Dividend Growth Model formula:-

g = 12.84%

So, expected growth rate is 12.84%

b). Equity Portion in Total Operating Assets = 60%

Equity AMount = $10 billion*60%

= $6 billion

Firm's Expected net income = $1.2 billion

Firm's ROE = Net Income/Total Shareholder's equity

= $1.2 billion/$6 billion

= 20%

Growth Rate = (1- Payout ratio)*ROE

0.1284 = (1 - Payout Ratio)*0.20

(1 - Payout Ratio) = 0.1284/0.20

(1 - Payout Ratio) = 0.642

Payout Ratio = 1 - 0.642

Payout Ratio = 35.80%

So, Portion of Net Income expected to be payout as dividend is 35.80%