1.Youcanusethetypicalreinvestmentratesforfirmsinthe
industrytowhichthefirmbelongs.Asimplewaytodothisis
tousetheaveragecapitalexpendituretodepreciationratiofor
theindustry(orbetterstill,juststablefirmsintheindustry)to
estimate a normalized capital expenditure for the firm.
2.Alternatively,youcanusetherelationshipbetweengrowth
and fundamentals developed in Chapter 4 to estimate the
required reinvestment.The expectedgrowth in netincome
can be written as:
This allows us to estimate the equity reinvestment rate:
Toillustrate,afirmwithastablegrowthrateof 4 percentand
areturnonequityof 12 percentwouldneedtoreinvestabout
athirdofitsnetincomebackintonetcapitalexpendituresand
workingcapitalneeds.Putanotherway,thefreecashflowsto
equity should be two-thirds of net income.
Thismodel,liketheGordongrowthmodel,isbestsuitedfor
firms growing at a rate comparable to or lower than the
nominal growth in theeconomy.It is, however, thebetter
modeltouseforstablefirmsthatpayoutdividendsthatare
unsus-tainably high (because they exceed FCFE by a
significantamount)oraresignificantlylowerthantheFCFE.
Note,though,thatifthefirmisstableandpaysoutsitsFCFE
asdividends,thevalueobtainedfromthismodelwillbethe
same as the one obtained from the Gordon growth model.