Investors use WACC to judge companies.
Investors can use return on equity (ROE) to help calculate the weighted average cost of capital (WACC) of a company. WACC shows the cost a company incurs to raise capital. In order to calculate WACC when you know ROE, you will also need to know several other pieces of information on the company. This information includes: the retention rate of dividends, the cost of equity, the cost of debt, and the company's effective tax rate. For example, a company has an ROE of 20 percent, a retention rate of dividends of 21 percent, a cost of equity of 10 percent, a cost of debt of 7 percent and effective tax rate of 30 percent.
Instructions
1. Multiply ROE by the retention rate of dividends. In the example, 0.2 times 0.21 equals 0.042. Label this g. The retention rate of dividends is the amount of income the company does not use to pay dividends. The formula for retention rate of dividends is net income minus dividends---then divided by net income.
2. Add the ROE to g. In the example, 0.2 plus 0.42 equals 0.242. This is Rs. ROE is the return on equity, if you do not know ROE then you calculate ROE by dividing dividend per share by share price.
3. Add together the cost of equity to the cost of debt to find total cost. In the example, 0.1 plus 0.07 equals 0.17. The cost of equity is the amount of a return a shareholder will want if he holds equity in a company. You can use the formula next years dividends per share divided by share price, then add the dividend growth rate. The cost of debt is the interest rate a company can borrow money at from lenders.
4. Divide cost of equity by the total cost. In the example, 0.1 divided by 0.17 equals 0.5882. This is the weight of equity.
5. Multiply Rs by the weight of equity. This is the equity side of the equation. In the example, 0.242 times 0.5882 equals 0.1423.
6. Subtract the tax rate from 1. This is the tax savings on debt. In the example, 1 minus 0.3 equals 0.7. The tax rate is the effective tax rate a company pays on all there income. The formula for effective tax rate is taxes paid divided by taxable income.
7. Divide the cost of debt by the total cost. In the example, 0.07 divided by 0.17 equals 0.4118.
8. Multiply the cost of debt by the weight of debt by the tax savings on debt. In the example, 0.7 times 0.4118 times 0.07 equals 0.0202. This is the debt portion of the equation.
9. Add together the equity portion of the equation and the debt portion of the equation to find WACC. In the example, 0.1423 plus 0.0202 equals 0.1625 or 16.25 percent.
Tags: cost debt, , rate dividends, , retention rate dividends,