Problem #3 -- ANALYTICAL THINKING AND CONCEPT INTEGRATION: Kahn Inc. (KI) is a d

Question

Problem #3 -- ANALYTICAL THINKING AND CONCEPT INTEGRATION: Kahn Inc. (KI) is a distributor of intellectual property. Suppose that you are a member of the financial analyst team at Franklin Templeton Investments (FTI) and have ascertained the following about KI as of June 15, 2018:

KI’s management desires to maintain a target capital structure of 60% common equity and 40% debt to fund its $10 billion in operating assets.

KI’s WACC is 13%;

KI has a before-tax cost of debt of 10%, and a corporate tax rate of 25%;

KI’s forecast net income is expected to be $1.1 billion;

KI’s retained earnings (aka, internally generated funds) are sufficient to cover all of the equity portion of its capital budget; that is, Ki will not need to issue new common stock for any upcoming capital expenditures (CAPEX);

KI’s expected dividend next year is $3 per common share;

KI’s current stock price is $35.

HINTS: See BH.09 section 9.5B, self-test example ST2, and this related instructional video at https://www.youtube.com/watch?v=2HD4e1jYulU

TASKS: Please -

Define a corporation’s “sustainable growth rate” and its significance to that corporation’s “capital structure” and “capital budget”;

Calculate KI’s expected growth rate;

Determine the portion of KI’s income that it will be expected to pay out as dividends to shareholders if it adheres to its target debt : equity ratio.

Based on the financial information you have developed for this case scenario, forecast KI’s assets, liabilities, and shareholders’ equity for its next fiscal year ended June 15, 2019. Be sure to state assumptions and logic !

Explanation / Answer

Sustainable growth rate is defined as the rate at which the company can grow without running into problems. It also does not have to borrow money to fund its growth but by using the internal revenue generated by the company.

Sustainable growth rate is the maximum growth rate on the base sales without any extra financing thus keeping a constant capital structure. Hence if a sustainable growth rate is maintained by the company then it's capital structure does not need to change.

Sustainable growth rate effects the capital budgeting decisions because if we need a sustainable growth rate then it needs to invest in technologies that provide sustainable results without any fail, so the company will not invest in risky projects which might provide higher returns but also has a chance of downfall.

KI expected growth rate - Next year dividend/ Current stock price = 3/35 = 8.5%

KI equity - 0.6*10 = 6 billion

KI shares - 6000/35 = 171.4 million

KI portion of Income if it has same debt equity ratio = 3*171.4 = 514.28 million

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