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

NI + Int ( 1−t ) D NI + Int ( 1−t ) Int ( 1−t )

ROA+ D
E
( ROA −i ( 1−t ) )=
( D+ E )
+
E (
( D+ E )
−
D )
D NI + Int ( 1−t ) D Int (1−t )
ROA+
E
( ROA −i ( 1−t ) )= ( ( D+ E ) )(
× 1+
E
−
E )
D NI Int (1−t ) D×NI D×Int ( 1−t ) Int ( 1−t )
ROA+
E
( ROA −i ( 1−t ) )= + (( + +
D+ E ) ( D+ E ) E×( D+ E ) E×( D + E )
−
E )
D E×NI E×Int ( 1−t ) D×NI D×Int ( 1−t ) Int ( 1−t )
ROA+
E
( ROA −i ( 1−t ) )= ( + +
E×( D+ E ) E×( D+ E ) E× ( D+ E ) E×( D+ E )
+ −
E )
 E  NI E  Int 1  t  D  NI D  Int 1  t   Int1  t 
ROA  D  ROA  i 1  t         
E  E   D  E E   D  E E   D  E E   D  E  E
NI + Int (1−t ) ) ×( D+ E ) Int ( 1−t ) NI Int ( 1−t ) Int ( 1−t )
ROA+
D
E
( ROA −i ( 1−t ) )= (( E×( D+ E )
− ) D
=
E
+
E
−
E
NI
ROA+ D ( ROA −i ( 1−t ) )= = ROE
E E

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

g L=( 1− payout )×ROE

(see Corporate Finance textbook on how to derive this)
gU =( 1− payout )×ROA

D
g L=( 1− payout )× ROA + ( E
( ROA−i ( 1−t ) ) )
with
D gU
ROE=ROA + ( ROA−i ( 1−t ) ) and ROA=
E (1− payout )

gU D gU
g L=( 1− payout )×
( ( 1− payout )
+ (
E ( 1−payout )
−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
Firm Leverage D/(D
D/(D+E) 23.1% 231 Leverage (L) 35%
D/E 30.0% Gearing = L/(1-L) 30%
1 0%
i 10.0% 100 Interest rate
25% 40%
t 33.0% 330 Tax rate

Growth Levered Firm

Growth Unlevered Firm As Input Parameter 20%
70%
gU 6.5% 65 15%
Breakeven Lin
10%

Growth Levered Firm 5%

gL 7.0% (1+D/E)*gU - {D/E*(1-Payout)*i*(1-t)} 0% Dividend Payout
-5%
Breakeven 4.69% =(1-Payout)*i*(1-t) Interest rate
-10%
Implied ROA 9.3% =gU/(1-Payout) Tax rate
-15%
Implied ROE 10.1% =gL/(1-Payout) 0% 2% 4% 6% 8% 10% 12%
Growth Unlevered Firm

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

 Firm Leverage D/(D+E)

0%
40%
70%
Breakeven Line

Dividend Payout 30.0%

Interest rate 10.0%

Tax rate 33.0%

% 10% 12% Linked cells
irm 40 70
7.04% 0% 40% 70%
0.00% 0.0% -3.1% -10.9%
1.00% 1.0% -1.5% -7.6%
2.00% 2.0% 0.2% -4.3%
3.00% 3.0% 1.9% -0.9%
4.00% 4.0% 3.5% 2.4%
5.0% 5.0% 5.2% 5.7%
6.00% 6.0% 6.9% 9.1%
7.00% 7.0% 8.5% 12.4%
8.00% 8.0% 10.2% 15.7%
9.00% 9.0% 11.9% 19.1%
10.00% 10.0% 13.5% 22.4%
11.00% 11.0% 15.2% 25.7%

Breakeven Line
4.7% 28.30%
4.7% -12.04%

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