Kahn Inc. has a target capital structure of 70% common equity and 30% debt to fu

Question

Kahn Inc. has a target capital structure of 70% common equity and 30% debt to fund its $9 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 16%, 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 $3, and the current stock price is $30.

a. 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.

b. If the firm's net income is expected to be $1.6 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

WACC=after tax cost of debt*proportion of debt+cost of equity*proportion of equity
after tax cost of debt=11%*(1-40%)=6.6%
proportion of debt=30%
proportion of equity=70%
So, WACC=6.6%*30%+cost of equity*70%
Given WACC=16%
Hence, 16%=6.6%*30%+cost of equity*70%
So, cost of equity=(16%-6.6%*30%)/70%=20.0286%

Price=D1/(cost of equity-growth rate)
Given, D1=3
Price=30
growth rate=cost of equity-D1/Price=20.0286%-3/30=10.0286%

growth rate=(1-payout ratio)*RoE
Given, RoE=1.6/(70%*9)=25.3968%
hence, payout ratio=1-growth rate/ROE=1-10.0286%/25.3968%=60.5123%=0.605123

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