Question

WACC and Cost of Common Equity

Kahn Inc. has a target capital structure of 45% common equity and 55% debt to fund its $10 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 12%, a before-tax cost of debt of 10%, and a tax rate of 25%. 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 $34.
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

A. What is the company's expected growth rate?

current stock price = expected dividend / (required rate of return - growth rate)

$34 = $3 / (12% - g)

12% - g = $3 / $34 = 8.82%

growth rate = 12% - 8.82% = 3.18%

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?

WACC = (equity x Re) + [debt x cost of debt x (1 - tax rate)]

12% = (45% x Re) + (55% x 10% x 0.75) = 0.45Re + 4.125%

0.45Re = 12% - 4.125% = 7.875%

Re = 7.875% / .45 = 17.5%

growth rate = (net income / equity) x (1 - dividend payout ratio)

3.18% = ($1.6 billion / $4.5 billion) x (1 - dividend payout ratio)

3.18% = 0.3556 x (1 - dividend payout ratio)

1 - dividend payout ratio = 3.18 / 0.3556 = 0.089

dividend payout ratio = 1 - 0.089 = 0.911

this means that the company distribute 91.1% of its net income to its stockholders