Question

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 16%, a before-tax cost of debt of 12%, 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 $2, and the current stock price is $25.

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

     

2. If the firm's net income is expected to be $1.0 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

WACC = We * Ke + Wd* Kd*(1 - tax)

where , Ke and Kd = cost of equity and Debt

given WACC 16%

0.16 = (0.65*Ke) + 0.35*0.12(1 - 0.25)

solving for Ke we get

cost of equity = 19.77%

a)

current price = D1 / (Ke - g)

where g = growth rate

25 = 2 /( 0.1977 - g)

so growth rate = 11.77%

b)

total = $10billion

equity = 65% i.e., 10 x 65% = $6.5 billion

Net income = $1 billion

ROE = Net income / equity

= 1 / 6.5

= 15.38%

growth rate = (1 - Payout ratio)*ROE

11.77% = (1 - payout) *15.38%

so pay out = 23.50%