Question

Part B: Dividend Payout and Growth Ratios Recall from Module 1 the following two ratios:

Internal growth rate = (ROA ? RR) / [1-(ROA ? RR)] (Eq. 3-30)

where RR = Retention ratio = (Addition to retained earnings)/Net income (Eq. 3-31)

– The internal growth rate measures the amount of growth a firm can sustain if it uses only internal financing (retained earnings) to increase assets Sustainable growth rate = (ROE ? RR) / [1-(ROE ? RR)] (Eq. 3-33)

– If the firm uses retained earnings to support asset growth, the firm’s capital structure will change over time, i.e., the share of equity will increase relative to debt

– To maintain the same capital structure managers must use both debt and equity financing to support asset growth

– The sustainable growth rate measures the amount of growth a firm can achieve using internal equity and maintaining a constant debt ratio

1. For the firm selected for Part A, calculate its internal growth rate for the last fiscal year:

WACC 2.83%

Cost of debt, iD -1.74%

Corporate tax rate, TC—Estimated Tax Rate 35.81%

Total debt, D--% of Financing from Debt—Short Term Debt is $31.692 and Long Term Debt is $28,835 4 yr 28,524,750 +24,004,000 46.39% 52,528,750/.4639=113,232,916.60

Total equity, E--% of Financing from Equity 53.61% 133,232,916.60*.5361=60,704,166.58

Total firm value, V—Outstanding Shares x Current Price 960.98m x $252.72—Not listed on WACC website 173,937,083.20

Cost of equity, iE 6.25%

CAPM Components Beta, ? 6.25=3+.406(11-3) .406

Historical market return, iM Assumed 11%

Risk-free rate, iF Assumed 3%

Using data in the table confirm the accuracy of the site’s WACC calculation:

Weight of Equity E/(E+D) .5361*6.25 3.35063

Weighted Average Cost of Equity E/(E+D) ·iE 113,232,916.60*.5361=60,704,166.58

Weight of Debt D/(E+D) .4639*-1.74 -.80719

Pre-Tax Weighted Average Cost of Debt D/(E+D) ·iD 46.39/(53.61+46.39)*6.25 2.89938

After-Tax Weighted Cost of Debt D/(E+D) ·iD · (1- TC) 2.89*(1-.3581) 1.85

Weighted Average Cost of Capital = E/(E+D) · iE + D/(E+D) · iD · (1-Tc) 2.83 3.350+-.518=2.83

Solving for above table:

5361*6.25=3.350

28,524,750+24,004,000=52,528,750

52,528,750/.4639=113,232,916.60

113,232,916.60x.5361=60,704,166.58

6.25=3+Beta*(11-3)3+.406*(11-3)

.5361x6.25=3.350

.4639x-1.74=-.8071

-.8071*(1-.3581)=-.51814

3.350+-.51814=2.83

This is for United Healthcare UNH--I am so fustrated I cannot complete Part B

Internal & Sustainable Growth Rates

Answer 1

1.

Growth rate = retention ratio(b) * internal rate of return = b * r

as per gorden model

if cost of equity (K_e) > r i.e. if a firm can give more return retention should be 100% so the value or price of firm gets increased.

similarly if K_e < r retention ration should be zero i.e. share holders can get more return investing themselvesby finding other alternatives where they can fetch better return than company.

P = D/k_e + {r*(E-D)/k_e}/k_e, where

P = market price per share

D = dividend per share

E = earnings per share

r = internal rate of return of the firm