Question

Kahn Inc. has a target capital structure of 55% common equity and 45% debt to fund its $11 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 14%, a before-tax cost of debt of 12%, 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 $2, and the current stock price is $23.

1. 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.
   

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? (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

a]

cost of debt = before-tax cost of debt * (1 - tax rate)

cost of debt = 12% * (1 - 40%) ==> 7.2%

WACC = (weight of equity * cost of equity) + (weight of debt * cost of debt)

14% = (55% * cost of equity) + (45% * 7.2%)

(55% * cost of equity) = 10.76%

cost of equity = 19.56%

cost of equity = (next year dividend / current share price) + growth rate

0.195 = (2 / 23) + growth rate

growth rate = 0.195 - (2 / 23)

growth rate = 0.108, or 10.8%

b]

ROE = net income / total equity

total equity = 55% of $11 billion ==> $6.05 billion

ROE = $1.6 billion / $6.05 billion ==> 0.2645, or 26.45%

growth rate = (1 - payout ratio) * ROE

10.8% = (1 - payout ratio) * 26.45%

payout ratio = 0.5917, or 59.17%