isefficientlyusingitsresources,though, weshould
change the reinvestment rate to reflect industry
averages.- Themoreextremescenarioisafirmthathasdecided
toliquidateitselfovertimebynotreplacingassetsas
they become run-down and by drawing down
working capital. In this case, the expected growth
shouldbeestimatedusingthenegativereinvestment
rate. Not surprisingly, this will lead to a negative
expected growth rate and declining earnings over
time.
Return on Capital
Thereturnoncapitalisoftenbasedonthefirm’sreturnon
existing investments, where the book value of capital is
assumedtomeasurethecapitalinvestedintheseinvestments.
Implicitly,youassumethatthecurrentaccountingreturnon
capital is a good measure of the true returns earned on
existinginvestmentsandthatthisreturnisagoodproxyfor
returns that will be made on future investments. This
assumption,ofcourse,isopentoquestionforthefollowing
reasons.
- The book value of capital might not be a good
measure of the capital invested in existing
investments, since itreflects the historical cost of
these assets and accounting decisions on
depreciation. When thebook value understates the
capital invested, the return on capital will be
overstated; when book value overstates the capital
invested, thereturn on capital willbe understated.
This problem is exacerbated if the book value of