Question

Kahn Inc. has a target capital structure of 50% common equity and 50% debt to fund its $12 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 12%, a before-tax cost of debt of 9%, 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 $3 and the current stock price is $25.

What is the company's expected growth rate? Round your answer to two decimal places at the end of the calculations.

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? (Hint: Refer to Equation below.)

Growth rate = (1 - Payout ratio)ROE

Round your answer to two decimal places at the end of the calculations.

Answer 1

Examining the DCF approach to the cost of retained earnings, the expected growth rate can be determined from the cost of common equity, price, and expected dividend. However, first, this problem requires that the formula for WACC be used to determine the cost of common equity.

WACC = w_d(r_d)(1-T) + w_c(r_s)

12.0% = 0.5(9%)(1 - 0.4) + 0.5(r_s)

9.3% = 0.5r_s

r_s = 0.186 or 18.60%.

From the cost of common equity, the expected growth rate can now be determined.

r_s = D₁/P₀ + g

0.186 = $3/$25 + g

g = 0.066 or 6.60%.

From the formula for the long-run growth rate:

g = (1 - Div. payout ratio) x ROE = (1 - Div. payout ratio) x (NI/Equity)

0.066 = (1 - Div. payout ratio) x ($1,200 million/$6,000 million)

0.066 = (1 - Div. payout ratio) x 0.20

0.33 = (1 - Div. payout ratio)

Div. payout ratio = 0.67 or 67%.