increasingfunctionofthespreadbetweenthetwonumbers.
Conversely, the number will be negative if the return on
capital is less than the cost of capital.
Note that although the firm continues to grow operating
incomeandmakesnewinvestmentsafterthefifthyear,these
marginalinvestmentscreatenoadditionalvaluebecausethey
earnthecostofcapital.Adirectimplicationisthatitisnot
growth that creates value, but growth in conjunction with
excessreturns.Thisprovidesanewperspectiveonthequality
ofgrowth.Afirmcanbeincreasingitsoperatingincomeata
highrate,butifitisdoingsobyinvestinglargeamountsator
belowthecostofcapital,itwillnotbecreatingvalueandmay
actually be destroying it.
Thisfirmcouldalsohavebeenvaluedusingdiscountedcash
flowvaluation,withfreecashflowstothefirmdiscountedat
thecostofcapital.Thenexttableshowsexpectedfreecash
flowsandthefirmvalue(inmillions ofdollars),usingthe
costofcapitalof10%asthediscountrate.Inlookingatthis
valuation, note the following:
- Thecapital expenditures occurat thebeginning of
eachyearandthusareshown inthepreviousyear.
Theinvestmentof$10millioninyear 1 isshownin
year 0, the year 2 investment in year 1, and so on. - Inyear5,thenetinvestmentneededtosustaingrowth
iscomputedbyusingtwoassumptions—thatgrowth
inoperatingincomewouldbe5%ayearbeyondyear
5,andthatthereturnoncapitalonnewinvestments
startinginyear 6 (whichisshowninyear5)wouldbe
10%.