Problem 10-15 WACC and Cost of Common Equity Kahn Inc. has a target capital stru

Question

Problem 10-15
WACC and Cost of Common Equity

Kahn Inc. has a target capital structure of 40% common equity and 60% debt to fund its $10 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 15%, 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 $2 and the current stock price is $24.

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 $1.5 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.
_______ %

Explanation / Answer

1. Compnay's expected growth rate:

Given, WACC = 0.15,

Weight of debt = Wd = 0.6

Weight of equity =We =0.4

Cost of debt = Rd = 0.09*(1-0.4) = 0.054

Cost of equity = Re = x

WACC = Re*We + Rd* We

0.15 = 0.4x + 0.6*0.054

0.15 = 0.4x+ 0.0324

0.4x =0.1176

x =0.294 or 29.4%

Hence Re =0.294

The growth rate is given by the DDM Formula

Ke = D1/P0 +g

Ke = 0.294

D1 =2

P0 =24

G= ?

0.294 = 2/24 + g

g= 0.21067 = 21.07%

Hence companies expected growth rate is 21.07%

Part-B

To calculate the Payout ratio we need the ROE

ROE = Net Income /Shareholders equity = 1.5/4 = 0.375

Grwoth Rate is 0.2107

Hence the equition Growth rate = (1-payout ratio)ROE becomes

0.2107 = (1-payoutratio) 0.375

1-payout ratio = 0.5616

Hence Payout ratio is 0.4384 = 43.84%

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