The short answer is no.
Dividends are paid to shareholders as a portion of a company’s profits. If the company doesn’t make a profit, then there’s no money to make dividend payments.
Shareholders know this, so they’ll usually want to know the likelihood of a company making a profit before they choose to invest. To figure this out, you can use the WACC formula to figure out a company’s cost of capital.
So let’s talk about dividends, the cost of capital, and the WACC formula. Specifically, we’ll be answering these questions:
- What are dividends?
- What is the Cost of Capital?
- What is WACC?
- How do you use the WACC formula?
What are dividends?
Dividends are regular payments made to a company’s shareholders. They allow shareholders to make money from their investment without having to sell their shares.
The amount that’s paid depends on how much stock the shareholder owns, and the dividend rate set by the company directors. For example, if the dividend is 90p per year, and you own 100 shares, you’d get £90 in dividend payments at the end of the fiscal year.
The price of the company’s shares on the stock market don’t necessarily affect dividend payments, it’s just an amount decided by the company owners, and agreed upon by shareholders. However, usually the dividend amount will increase with profits.
Before buying shares, potential investors will want some assurance that they have a good chance of making money on their investment.
The best way to figure that out is by calculating a company’s cost of capital.
What is the Cost of Capital?
Generally speaking, the cost of capital represents a company’s risk. It will show whether or not a company’s business structure will return profits. It’s an essential figure to know, and can be used by companies to:
- See if their business structure will be profitable.
- Make decisions about the best way to raise funds (like taking out loans, or seeking investors).
- Present to potential shareholders, to convince them to invest.
Figuring out a company’s cost of capital can be tricky, and is never an exact figure, but most people use the weighted average cost of capital (WACC) formula.
For more information about the cost of capital, check out our article on how to calculate the cost of capital.
What is WACC?
Figuring out the WACC for your company requires a little bit of accounting maths. And to do that, you’ll need some figures. The WACC formula looks like this:
WACC = (E/V x Re) + ((D/V x Rd) x (1-T))
In this formula, the letters stand for:
E = Market value of the business’s equity
V = Total value of capital (equity + debt)
Re = Cost of equity
D = Market value of the business’ debt
Rd = Cost of debt
T = Tax rate
There are a lot of moving parts here, so let’s look at what each term means.
Market value of the business’ equity (E)
The market value of equity is the company’s current stock price multiplied by the total number of shares.
Total value of capital (V)
The total value of all the company’s assets and money. You can find this by deducting the market value of the business’ debt from the market value of the business’ equity.
Cost of equity (Re)
Calculating the cost of equity is one of the more difficult figures to calculate because capital doesn’t have a set price. Its value depends on how much investors are willing to pay.
If shareholders choose to sell their shares to your company, it decreases the company’s value. So the cost of equity is the amount your business must spend to maintain a good share price.
Market value of the business’ debt (D)
This is the total amount of debt a business has, including the debt that isn’t reported in their books (like bank debt).
Cost of debt (Rd)
To calculate the cost of debt, you use the market interest rate (standard interest rate in the market) or the actual interest rate the company currently pays on its debt.
Interest is also tax-deductible, so investors need to account for the tax savings your company could take advantage of when making its interest payments.
Tax rate (T)
This one is fairly simple. For limited companies, just use the corporation tax rate – 19%.
Unincorporated businesses like sole traders are taxed through income tax bands. Normally those tax rates aren’t used in the WACC formula because it’s a projection for potential shareholders, and unincorporated businesses don’t have shareholders.
But sole traders and small businesses often still use the WACC formula to see how their business would perform when it transitions into a company.
How do you use the WACC formula?
So you’ve got all your info, put it into the formula, and got a result as a percentage. But what does it all mean?
The WACC shows your profits compared to your costs, so it shows investors how much money you could have to pay back debts and dividends. Let’s look at 2 examples.
If your company yields an average profit of 15%, and has an average cost of 5% per year, then the company essentially makes a 10% profit on every £1 it invests in itself. Investors see this as your company generating 10p for every £1 they invest, a value that can be distributed to shareholders as dividends or to pay off debt.
Alternatively, let’s say your company only makes a 10% profit at the end of the year but has an average cost of 15%. In this case, your company loses 5p on every £1 it invests in itself, meaning there’d be no profits left over to pay dividends or debts. Investors would probably shy away from a company like that because there’s little chance of them seeing a return on their investment.
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