Tag Archives | return on investment

ROE (Return on Equity)

See Also:
Return On Equity Example
Return on Asset
Return on Equity Analysis
Financial Leverage
Gross Profit Margin Ratio Analysis
Fixed Asset Turnover Analysis

Return on Equity (ROE)

The return on equity, or ROE, is defined as the amount of profit or net income a company earns per investment dollar. It reveals how much profit a company earns with the money shareholders have invested. The investment dollars differ in that it only accounts for common shareholders. This is often beneficial because it allows companies and investors alike to see what sort of return the voting shareholders are getting, if preferred, and other types of shares that are not counted.

The term can be confusing as it has various aliases. Return on Equity used to be called Return on Common Equity; however, ROCE now refers to Return on Capital Employed. Return on Equity is equivalent to Return on Net Worth (RONW).

Return on Equity Explanation (ROE) 

ROE is a measure of how well a company uses its investment dollars to generate profits; often times, it is more important to a shareholder than return on investment (ROI). It tells common stock investors how effectively their capital is being reinvested. A company with high return on equity (ROE) is more successful in generating cash internally. Investors are always looking for companies with high and growing returns on common equity. However, not all high ROE companies make good investments. The better benchmark is to compare a company’s return on common equity with its industry average. The higher the ratio, the better the company.

(Are you trying to maximize the value of your company? The first thing to do is to identify “destroyers” that can impact your company’s value. Click here to download your free “Top 10 Destroyers of Value“.)

Return on Equity (ROE) Formula

The return on equity formula is as follows:

ROE = Net Income (NI)/ Average Shareholder’s Equity

The Net Income accounts for the full fiscal year (prior to dividends paid to common stock holders and after dividends paid to preferred stock holders).

The average shareholder’s equity is found by combining the beginning common stock for the year, on the balance sheet, and the ending common stock value. These values are then divided by two for the average amount in the year and do not include preferred shares.

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Analyzing Your Return on Investment (ROI)

return on investmentReturn on Investment is a useful tool to understand, analyze, and compare different investment opportunities. ROI measures the efficiency of a specific investment by revealing how net earnings recover the cost of the original investment. Have you ever wondered if the result of your investment was really worth the cost? Well, a return on investment model looks at the inputs and assumptions of the ROI equation to determine if the benefits of the investment are worth the costs. Following are the ROI model tools you need to analyze ROI and improve ROI so that you can determine the value of your investment:

The first step is to identify and analyze overall benefits from the investment. For different financial situations, the percentage of returns may vary according to what the decision-makers consider to be gains or losses from the investment. As long as you are consistent with how you classify benefits of the investment, you should be able to effectively use your calculations for analysis and comparisons. Focus on benefits which are measurable and attainable. Tangible benefits can be measured and evaluated to improve ROI percentages.

If the benefits appear significant, the next step is to identify and analyze associated costs of the investment. Costs are simpler to identify than benefits. Make a list of costs and then breakdown the costs into groups to better categorize the origination of costs. This will enable you to understand where the majority of costs are coming from. Are there any costs that appear inflated? Can you easily reduce some costs? Are there costs that could be eliminated completely? These questions will help you analyze expenses of the investment. Keep in mind that the cost of an investment includes not only the start-up cost, but also the maintenance and improvement of the investment over time.

To improve the return on your investment, business managers and directors should develop comprehensive and realistic projections for both revenues and expenses. Effective planning will account for unexpected expenses and underperforming sales revenue. By analyzing projections, you should be able to develop strategies to reduce costs and increase sales.

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Profitability Index Method Formula

See Also:
Profitability Index Method

Profitability Index Method Formula

Profitability Index = (PV of future cash flows) ÷ Initial investment: This of course being where PV = the present value of the future cash flows in question.

Or = (NPV + Initial investment) ÷ Initial Investment: As one would expect, the NPV stands for the Net Present Value of the initial investment.

Profitability Index Calculation

Example: a company invested $20,000 for a project and expected NPV of that project is $5,000.

Profitability Index = (20,000 + 5,000) / 20,000 = 1.25

That means a company should perform the investment project because profitability index is greater than 1.

Profitability Index Example

Texabonds Inc has decided to consider a project where they predict the annual cash flows to be $5,000, $3,000 and $4,000, respectively for the next three years. At the beginning of the project, the initial investment put into the project is $10,000. Use the Profitability Index Method and a discount rate of 12% to determine if this is a good project to undertake. In order to solve this problem, it is probably a good idea to make a table so that the numbers can be organized by year. Using a PI table, the following PVIF’s are found respectively for the 3 years: .893, .797, .712. Once the PVIF’s are determined, simply multiply the cash flows and the PVIF’s together in order to get the PV of cash flows for each respective year ($4,465, $2,391, $2,848). Adding up all the PV’s will get the total present value of the project which is $9,704. Divide that final number by the original investment $10,000 and the PI has been determined: .9704. As one can see, the Profitability Index is less than 1 so the project should be scrapped. The NPV can also be determined by subtracting the initial investment ($10,000) from the total PV of the project ($9,704) and you are left with -$296. In this case, because the number is negative, NPV also says that the project should be rejected. A table for the problem is shown below:

YearCash FlowPVIF at 12%PV of Cash Flow
1$5,000.893$4,465
2 3,000.797 2,391
3 4,000.712       __2,848__
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Make-or-Buy Business Decision

See Also:
Company Life Cycle
Market Positioning
Marking to Market
Mining the Balance Sheet for Working Capital
Inventory to Working Capital

Make-or-Buy Business Decision

Make-or-buy decisions arise in business when a company must decide whether to produce goods internally or to purchase them externally. This typically is an issue when a company has the ability to manufacture material inputs required for its production operations that are also available for purchase in the marketplace. For example, a computer company may need to decide whether to manufacture circuit boards internally or purchase them from a supplier.

When analyzing a make-or-buy business decision, it is necessary to look at several factors. The analysis must examine thoroughly all of the costs related to manufacturing the product as well as all the costs related to purchasing the product. Such analysis must include quantitative factors and qualitative factors. The analysis must also separate relevant costs from irrelevant costs and look only at the relevant costs. The analysis must also consider the availability of the product and the quality of the product under each of the two scenarios.

Identify the “destroyers” of value that can impact your company’s value. Click here to download your free “Top 10 Destroyers of Value“.

Quantitative vs. Qualitative Analysis

The make-or-buy decision involves both quantitative analysis and qualitative analysis. Quantitative considerations can be calculated and compared; qualitative considerations require subjective judgment and often need multiple opinions. Also, some of the factors involved can be quantified with certainty, while other factors must be estimated. The make-or-buy decision requires thorough analysis from all angles.

Quantitative factors to consider may include things such as the availability of production facilities, production capacity, and required resources. They may also include fixed and variable costs that can be determined with certainty or estimated. Similarly, quantitative costs will include the price of the product under consideration as it is being priced by suppliers offering the product in the marketplace for sale.

Qualitative factors to consider require more subjective judgment. Examples of qualitative factors include the reputation and reliability of the suppliers, the long-term outlook regarding production or purchasing the product, and the possibility of changing or altering the decision in the future and the likelihood of changing or reversing the decision at a future date.

Relevant Costs and Irrelevant Costs

When making the make-or-buy decision, it is necessary to distinguish between relevant and irrelevant costs. Relevant cost for making the product are all the costs that could be avoided by not making the product as well as the opportunity cost incurred by using the production facilities to make the product as opposed to the next best alternative usage of the production facilities. Relevant costs for purchasing the product are all the costs associated with buying it from suppliers. Irrelevant costs are the costs that will be incurred regardless of whether the product is manufactured internally or purchased externally.

After you’ve identified the relevant costs and irrelevant costs in your company, download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.

Make-or-buy business decision

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Weighted Average Cost of Capital (WACC)

See Also:
Capital Asset Pricing Model
Cost of Capital Funding
Arbitrage Pricing Theory
APV Valuation
Capital Budgeting Methods
Discount Rates NPV
Required Rate of Return

Weighted Average Cost of Capital Definition

Weighted average cost of capital, defined as the overall cost of capital for all funding sources in a company, is used as commonly in private businesses as it is in public businesses.

A company can raise its money from three sources: equity, debt, and preferred stock. The total cost of capital is defined as the weighted average of each of these costs.

Weighted Average Cost of Capital Meaning

Weighted average cost of capital means an expression of the overall requited return on the company’s investment. It is useful for investors to see if projects or investments or purchases are worthwhile to undertake. It is equally as useful to see if the company can afford capital or to indicate which sources of capital will be more or less useful than others. It has also been explained as the minimum return a company can make to repay capital providers.

Weighted Average Cost of Capital Formula

The most popular method to calculate cost of capital is through using the Weighted Average Cost of Capital formula.

WACC = Ke *(E/(D+E+PS)) + Kd*(D/(D+E+PS))*(1-T) + Kps*(PS/(D+E+PS))

Where:
Ke = cost of equity
Kd = cost of debt
Kps= cost of preferred stock
E = market value of equity
D = market value of debt
PS= market value of preferred stock
T = tax rate

Ke reflects the riskiness of the equity investment in the company. Kd reflects the default risk of the company, and Kps reflects its intermediate standing in terms of risk between debt and equity. The weights of each of these components reflect their market value proportions and measure how the existing company is financed.

Weighted Average Cost of Capital Calculation

Weighted average cost of capital calculation, though sometimes complex, will yield very useful results.

Example: a company finances its business 70% from equity, 10% from preferred stock, and 20% from debt. Ke is 10%, Kd is 4%, and Kps is 5%. The tax rate is 30%. The required rate of return of this company according to the WACC is:

(70% * 10%) + (20% * 4%) + (10% * 5%) = 8.3%

That means the required return on capital is 8.3%. A company pays 8.3% interest for every dollar it finances.

Are you in the process of selling your company? The first thing to do is to identify “destroyers” that can impact your company’s value. Click here to download your free “Top 10 Destroyers of Value“.

Weighted Average Cost of Capital Examples

Tim is creating a web 2.0 startup business called Webco. Tim, an avid user of the web and recent college graduate, has quite a bit to learn. He relies off of his networking ability and mentors to receive much needed advice.

Tim has prepared a full business plan. He is now moving his company to the next level by beginning to find capital providers. He has an expected range of the returns each source of available capital will require. Now, Tim needs to use the weighted average cost of capital method to decide whether his company will be able to receive capital from certain providers.

After doing some research, Tim is prepared to make his calculation. His results are below:

Tim’s company is considering financing its business 70% from equity, 10% from preferred stock, and 20% from debt. Ke is 10%, Kd is 4%, and Kps is 5%. The tax rate is 30%.

(70% * 10%) + (20% * 4%) + (10% * 5%) = 8.3% = WACC

That means the required return on capital is 8.3%. A company pays 8.3% interest for every dollar it finances.

Tim’s company, according to his calculations, will not be able to create the returns required to work with the mix of capital which is listed above. He resolves to do more research and come back at the problem with a new approach.

Overall, Tim is satisfied. Though he has not seen the results that he was looking for, he was able to avoid a costly mistake by creating a plan before he began. He has confidence that despite this setback his career has a bright future.

If you’re looking to sell your company, download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.

Weighted average cost of capital

Strategic CFO Lab Member Extra

Access your Exit Strategy Checklist Execution Plan in SCFO Lab. The step-by-step plan to get the most value out of your company when you sell.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

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