   Chapter 10, Problem 15P Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

Solutions

Chapter
Section Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

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.

Summary Introduction

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.

Explanation

Given information:

Next expected dividend ( D1 ) is $3 Cost of common equity is 17.67% (working note). Current price of stock is$35.

The formula of the cost of common equity is:

rs=D1P0+g

Where

• rs is the cost of common equity.
• D1 is the next expected dividend.
• P0 is the current price of the stock.
• g is the constant growth rate.

Substitute $3 for D1 ,$35 for P0 and 0.1767 for rs in above formula.

0.1767=$3$35+g0.1767=0.0857+gg=0.17670.0857g=9.10%

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.

Summary Introduction

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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