Question

Kahn Inc. has a target capital structure of 60% common equity and 40% debt to fund its $10 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 13%, a before-tax cost of debt of 10%, 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 $35.

a. What is the company’s expected growth rate?
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?

Answer 1

Answer and Explanation:

The computation is shown below

a. Given that

WACC = 13%

Before-tax cost of debt = 10%

As we know that

WACC = After tax Cost of debt × Weight of debt + Cost of equity × weight of equity

13% = 10% × (1 - 0.40) × 0.40 + X × 0.60

13% = 6% × 0.40 + X × 0.60

13% = 2.4% + X × 0.60

10.6% = X × 0.60

X = 17.67%

Now

Cost of equity = D1 ÷ Price + g

0.1767 = $3 ÷ 35 + g

g = 9.10%

Now

B) Growth rate = (1 - payout ratio) × ROE

.0910 = ( 1 - X) × 0.2667

Payout ratio = 65.88

As we know that

ROE = net income ÷ shareholders equity

= $1.6 billion ÷ $6 billion

= 26.67%

Now the portion of the net income for the dividend would be

= 65.88 × $1.6 billion

= 1.054 billion