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WACC AND COST OF COMMON EQUITY 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 $1.1 billion, what portion of its net income is the firm expected to pay out as dividends? (Hint: Refer to Equation 9.4 in Chapter 9.)
a.
To determine: The expected growth rate of the company.
Introduction:
Weighted Average Cost of Capital
It is the weighted average cost of capital of all the sources through which the firm finances its capital. It is the rate that a company will pay to all for raising finance. It can be termed as the firm’s cost of capital. The company raises money through various sources such as common stock and preference share debt. The WACC is calculated by taking the relative weight of each item of the capital structure.
Expected growth rate
Common stocks grow at a fixed rate which is called as the expected growth rate. It is the rate at which company’s stocks are likely to grow.
Given information:
Next expected dividend (
Cost of common equity is 17.67% (working note).
Current price of stock is $35.
The formula of the cost of common equity is:
Where
-
-
-
- g is the constant growth rate.
Substitute $3 for
Thus Company’s expected growth rate is 9.10%.
Working note:
Compute cost of equity.
Given,
WACC is 13%.
Weight of debt is 40%
Tax rate is 40%
b.
To determine: The portion of the firm’s net income that is expected to be paid out as dividend.
Introduction:
Dividend Payout Ratio
The amount distributed as dividend to the stockholders of the company in respect of the total net income is called as the dividend payout ratio.
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