Finally,lookingatfreecashflowstothefirm,weestimated
theexpectedgrowthinoperatingincomeasafunctionofthe
return on capital and the reinvestment rate:
Again,algebraicmanipulation yieldsthefollowingmeasure
of the reinvestment rate in stable growth.
where theROCn isthereturnon capitalthat thefirmcan
sustaininstablegrowth.Thisreinvestmentratecanthenbe
usedtogeneratethefreecashflowtothefirminthefirstyear
of stable growth.
Linkingthereinvestmentrateandretentionratiotothestable
growth rate also makes the valuation less sensitive to
assumptions about stable growth. Although increasing the
stablegrowthrate,holdingallelseconstant,candramatically
increasevalue,changingthereinvestmentrateasthegrowth
ratechangeswillcreateanoffsettingeffect.Thegainsfrom
increasing the growth rate will be partially or completely
offset by the loss in cash flows because of the higher
reinvestmentrate.Whethervalueincreasesordecreasesasthe
stable growth increases will entirely depend on what you
assumeaboutexcessreturns.Ifthereturnoncapitalishigher
thanthecostofcapitalinthestablegrowthperiod,increasing
thestable growthratewill increasevalue. Ifthereturn on
capitalisequaltothestablegrowthrate,increasingthestable
growthratewillhavenoeffectonvalue.Thiscanbeproved
quite easily.