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 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 $25.

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

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? Do not round intermediate calculations. Round your answer to two decimal places. (Hint: Refer to Equation below.) Growth rate = (1 - Payout ratio)ROE

Answer 1

Answer :

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 = wd(rd)(1-T) + wc(rs)

12.0% = 0.5 (9%)(1 - 0.25) + 0.5(rs)

8.625% = 0.5rs

rs = 0.1725 or 17.25%.

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

rs = D1/P0 + g

0.1725 = $3 / $25 + g

g = 0.0525 or 5.25%.

From the formula for the long-run growth rate:

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

0.0525 = (1 - Div. payout ratio) x ($1,100 million/$6,000 million)

0.0525 = (1 - Div. payout ratio) x 0.1833

0.29 = (1 - Div. payout ratio)

Div. payout ratio = 0.71 or 71%.