Question

WACC AND COST OF COMMON EQUITY

Kahn Inc. has a target capital structure of 65% common equity and 35% debt to fund its $10 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 13%, a before-tax cost of debt of 8%, 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 $25.

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. 
   
3. If the firm's net income is expected to be $2.0 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). WACC = [wD x kD x (1 - t)] + [wE x kE]

13% = [0.35 x 8% x (1 - 0.40)] + [0.65 x kE]

13% = 1.68% + [0.65 x kE]

kE = [13% - 1.68%] / 0.65 = 11.32% / 0.65 = 17.42%

P0 = D1 / [r - g]

$25 = $2 / [0.1742 - g]

0.1742 - g = $2 / $25

g = 0.1742 - 0.08 = 0.0942, or 9.42%

b). value of equity = value of asset * share of equity = $10 billion * 65% = $6.5 billion.

Return on equity = Net Income / Equity = $2 billion / $6.5 billion = 30.77%

growth rate = return on equity * (1 - dividend payout ratio)

9.42% = 30.77% * (1 - DPR)

DPR = 1 - [9.42% / 30.77%] = 1 - 0.306 = 0.694, or 69.40%