Kruger Industrial Smoothing has a target capital structure of 60% common equity

Question

Kruger Industrial Smoothing has a target capital structure of 60% common equity and 40% debt and is looking to fund $5 billion in capital projects for the next year. Kruger has a target WACC of 11.5%, bonds that sell at par with a coupon rate of 9% and a tax rate of 40%. The company hopes their retained earnings will be adequate to fund the equity portion of Kruger's capital budget. Kruger expects to pay a year-end dividend of S3.50 and their common stock currently sells for S32. 4. (6 points) a. What is Kruger's growth rate? Kruger expects net income for the year to be approximately $525 million and they anticipate paying out 45% of those earnings in dividends. What is Kruger's breakpoint in retained earnings? b.

Explanation / Answer

(a)

Equity = 0.6 and Debt = 0.4, WACC = 11.5 % , Tax Rate = 40 %, As bonds sell at par, before-tax cost of debt = coupon rate = kd = 9 %

Let the cost of equity be ke

Therefore, 11.5 = 0.6 x ke + kd x (1-t) x 0.4

11.5 = 0.6 x ke + 9 x (1-0.4) x 0.4

0.6 x ke = 11.5 - 2.16

ke = 15.567 %

Expected Dividend = D1 = $ 3.5 and Current Stock Price = P0 = $ 32 and let the growth rate be g

ke = (D1/P0) + g

0.15567 = (3.5/32) + g

g = 0.046295 or 4.6295 %

(b) Retained Earnings breakpoint will occur when the maximum value of retained earnings is exhausted for the capital budget and additional common equity (in the form of new shares) will have to be issued to fund the equity portion of the capital budget.

Net Income = $ 525 million and Payout Ratio = 0.45

Retained Earnings = Net Income x (1-Payout Ratio) = 525 x (1-0.45) = $ 288.75 million

Proportion of Retained Earnings = 0.6

Therefore, Breakpoint = 288.75 / 0.6 = $ 481.25 million

This implies that when capital required exceeds $ 481.25 million, retained earnings is no longer sufficient to fund the equity portion of budget and hence new equity needs to be issued to fund additional capital. This, in turn, increases the cost of equity and consequently the marginal cost of capital.

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