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Estimating Growth Rate Formulas

Teaching model prepared by Kurt Hess, University of Waikato Management School


ROA 6.0% 60 Return on Assets = Net Income / Total Assets
Payout 25.0% 250 Dividend Payout Ratio
D/(D+E) 75.0% 750 Leverage (L)
D/E 3.00 Gearing = L/(1-L)
i 10.0% 100 Interest rate
t 33.0% 330 Tax rate

ROE 3.90% = ROA + D/E*(ROA- i*(1-t))

Growth Unlevered Firm


gU 4.50% = (1 - Payout) * ROA
Growth Levered Firm
gL 2.93% = (1 - Payout) * ROE
gL 2.93% direct formula: (1+D/E)*gU - {D/E*(1-Payout)*i*(1-t)}

Derive Relationship between ROE and ROA

ROA 
D
E
NI  Int  1−t  D
 ROA −i  1−t   =
 DE 

E  D E 


NI  Int  1−t  Int  1−t 
D 
ROA 
D
E
 ROA −i  1−t   =
NI  Int 
 D E  
1−t 
× 1
D
E

Int


E
1−t 

ROA
D
E
 ROA−i  1−t   = NI  
Int  1−t 

D× NI
 D E   D E  E ×  D E  E ×  D E 

D× Int  1−t 

Int  1−t 
E 
ROA 
D
E
 ROA −i  1−t   = E × NI 
E ×  D E   E× Int  1−t 
E × DE 

D× NI
E×  D E 

D× Int  1−t 
E ×  D E 


Int  1−t 
E

ROA + D ( ROA − i(1 − t ) ) = 
E × NI
+
E × Int ( 1 − t ) +
D × NI
+
D × Int ( 1 − t ) 
 −
Int ( 1 − t)
E  E × ( D + E) E × ( D + E) E × ( D + E) E × ( D + E)  E

ROA 
D
E
 ROA −i  1−t   =  NI Int  1−t   ×  D E 
E×  D E 

D 
Int  1−t  NI Int  1−t  Int  1−t 
=
E

E

E
D
ROA 
E
 ROA −i  1−t   = NI = ROE
E

Derive Growth Rate of Levered (g L ) and Unlevered (g L) Firm


g L = 1− payout × ROE
(see Corporate Finance textbook on how to derive this)
g U =  1− payout × ROA

g L = 1− payout × ROA  D
E
 ROA−i  1−t   
with
D gU
ROE = ROA   ROA −i 1−t   and ROA =
E  1− payout 

g L = 1− payout ×
 gU
 1− payout 

D
 gU
E  1− payout 
−i  1−t  

g L= g U 
D
E
g U −  1− payout ×i  1−t   

g L = 1
D
E × g − D E× 1− payout
U  ×i  1−t  

Kurt Hess, kurthess@waikato.ac.nz Page 1 Estimating Determining Growth Rates.xls


Visualizing Relationship Between Levered and Unlevered Growth Rate
Teaching model prepared by Kurt Hess, University of Waikato Management School
Payout 30.0% 300 Dividend Payout Ratio
100%
D/(D+E) 23.1% 231 Leverage (L)
90%
D/E 0.0% Gearing = L/(1-L) 0%
i 10.0% 100 Interest rate 80% 40%

Growth Levered Firm


t 33.0% 330 Tax rate 70% 70%
Growth Unlevered Firm As Input Parameter Breakeven Line
60%
gU 6.5% 65 50%

40%
Growth Levered Firm
30%
gL 0.0% (1+D/E)*gU - {D/E*(1-Payout)*i*(1-t)}
20%

Breakeven 4.69% =(1-Payout)*i*(1-t) 10%

Implied ROA 9.3% =gU/(1-Payout) 0% 1


0% 2% 4% 6% 8% 10%
Implied ROE 0.0% =gL/(1-Payout)
Growth Unlevered Firm

Kurt Hess, kurthess@waikato.ac.nz Page 2 Estimating Determining Growth Rates.xls


0%
40%
70%
Breakeven Line

1
6% 8% 10% 12%
Linked cells
h Unlevered Firm 40 70
0.00% 0% 40% 70%
0.00% 0.0% 0.0% 0.0%
1.00% 0.0% 0.0% 0.0%
2.00% 0.0% 0.0% 0.0%
3.00% 0.0% 0.0% 0.0%
4.00% 0.0% 0.0% 0.0%
5.0% 0.0% 0.0% 0.0%
6.00% 0.0% 0.0% 0.0%
7.00% 0.0% 0.0% 0.0%
8.00% 0.0% 0.0% 0.0%
9.00% 0.0% 0.0% 0.0%
10.00% 0.0% 0.0% 0.0%
11.00% 0.0% 0.0% 0.0%

Breakeven Line
4.7% 0.00%
4.7% 0.00%

Kurt Hess, kurthess@waikato.ac.nz Page 3 Estimating Determining Growth Rates.xls


1

0.00% 10.00%
10.00% 20.00%
20.00% 30.00%
30.00% 40.00%
40.00% 50.00%
50.00% 60.00%
60.00% 70.00%
70.00% 80.00%
80.00% 90.00%
89.00% 99.00%

Kurt Hess, kurthess@waikato.ac.nz Page 4 Estimating Determining Growth Rates.xls