Kahn Inc. has a target capital structure of 45% common equity and 55% debt to fu
ID: 2781411 • Letter: K
Question
Kahn Inc. has a target capital structure of 45% common equity and 55% debt to fund its $11 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 15%, a before-tax cost of debt of 12%, 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 $21.
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 $1.0 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.
%
Explanation / Answer
Answer a.
WACC = 15%
Before-tax Cost of Debt = 12%
tax rate = 40%
Weight of Equity = 45%
Weight of Debt = 55%
WACC = Weight of Debt*Before-tax Cost of Debt*(1-tax) + weight of Equity*Cost of Equity
15% = 55%*12%*(1-0.40) + 45%*Cost of Equity
15% = 3.96% + 45%*Cost of Equity
Cost of Equity = 24.53%
Cost of Equity = D1 / P0 + g (growth rate)
0.2453 = $2 / $21 + g
g = 0.1501
g = 15.01%
Expected growth rate is 15.01%
Answer b.
Current Capital Structure = $11 billion
Total Equity = 45%*$11 billion
Total Equity = $4.95 billion
ROE = Net Income / Total Equity
ROE = $1 billion / $4.95 billion
ROE = 20.20%
Growth Rate = (1 - Payout Ratio)*ROE
15.01% = (1 - Payout Ratio)*20.20%
1 - Payout Ratio = 0.7431
Payout Ratio = 0.2569 = 25.69%
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