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

Question

WACC and Cost of Common Equity Kahn Inc. has a target capital structure of 55% common equity and 45% debt to fund its $9 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 13%, 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 $23.

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 $1.0 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.

Explanation / Answer

Total Assets = 9 billion, Equity = 55% & Debt =45%

So, Total Equity = 9 * 55% = 4.95 billion & Total Debt = 9 * 45% = 4.05 billion

Before-tax Cost of Debt = 12% & Tax Rate = 40%

So, After-tax Cost of Debt = Before-tax Cost of Debt * (1 - Tax Rate) = 12% * (1 - 40%) = 7.20%

WACC = 13%

WACC = Percentage of Equity * Cost of Equity + Percentage of Debt * After-tax Cost of Debt

So, 13% = (55% * Cost of Equity) + (45% * 7.20%)

or, 13% = (55% * Cost of Equity) + 3.24%

or, (55% * Cost of Equity) = 9.76%

So, Cost of Equity = 9.76% / 55% = 17.75% [rounded to 2 decimals]

Expected Dividend = 2 & Current Stock Price = 23

Cost of Equity = (Expected Dividend/Current Stock Price) + Growth Rate

So, 17.75% = (2/23) + Growth Rate

or, Growth Rate = 17.75% - (2/23) = 17.75% - 8.70% = 9.05% [all calculations are rounded to 2 decimals]

So, Company's expected growth rate is 9.05%

Net Income = 1 billion

Total Equity = 4.95 billion

So, Return on Equity (ROE) = (1/4.95) * 100% = 20.20% [rounded to 2 decimals]

Growth rate = (1 - Payout ratio) * ROE

So, 9.05% = (1 - Payout Ratio) * 20.20%

or. 1 - Payout Ratio = 44.80%

or, Payout Ratio = 55.20%

So, if Firm's net income is expected to be $1.0 billion, then the firm is expected to pay out 55.20% of the net income as dividends.

Dividend Payout = 1 * 55.20% = 0.5520 billion

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