3. WACC and Cost of Common Equity Kahn Inc. has a target capital structure of 55

Question

3. WACC and Cost of Common Equity Kahn Inc. has a target capital structure of 55% common equity and 45% debt to fund its $10 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 14%, a before-tax cost of debt of 11%, 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 $4 and the current stock price is $27.

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.

If the firm's net income is expected to be $1.9 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.

Explanation / Answer

Kahn inc has to fund $10 billion assets by 55% equity and 45% debt.

Thus common equity is 55%*10 billion= $5.5 billion

Let us first find cost of equity ke

WACC= Cost of equity*weight of equity+ after tax cost of debt*weight of debt

14%= cost of equity*55%+(1-40%)*11%*45%

=cost of equity*55%+2.97%

cost of equity*55%= 11.03%

cost of equity= 20.05%

ROE= Net Income/Common Equity

=$1.9B/$5.5B*100

ROE=34.54%

Now Using gordon dividend growth model we can find growth rate as follows

ke= (D1/P0)+g

Ke= cost of equity D1 is next year dividend and P0 is current stock price

20.05%= 4/27+ g

g= 20.05%-14.81%

g=5.24%

The company's expected growth rate is 5.24%

Now,

Growth rate = (1 - Payout ratio)ROE

5.24%=(1 - Payout ratio)*34.54%

1 - Payout ratio= 0.1517

payout ratio= 1-0.1517

Payout ratio= 84.83%

It means that company will pay 84.83% of their net income as a dividend.

Net income =$1.9 Billion

Thus company wil pay 84.83%*1.9 Billion

=1.61 Billion

Dividend paid= $1.61Billion or 84.83% of net income

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