reestimatetheratingandthecostofdebtforafirmasyou
change its revenues and operating income.
Onthepracticalquestionofwhatdebtratioandcostofdebt
to use in stable growth, you should look at the financial
leverageoflargerandmorematurefirmsintheindustry.One
solutionistousetheindustryaveragedebtratioandcostof
debtasthedebtratioandcostofdebtforthefirminstable
growth.
Reinvestment and Retention Ratios
Stable-growth firms tendto reinvest less thanhigh-growth
firms, and itiscritical that weboth capture theeffects of
lowergrowthonreinvestmentandthatweensurethatthefirm
reinvests enough to sustain its stable growth rate in the
terminalphase.Theactualadjustmentwillvarydependingon
whether we are discounting dividends, free cash flows to
equity, or free cash flows to the firm.
Inthedividenddiscountmodel,notethattheexpectedgrowth
rateinearningspersharecanbewrittenasafunctionofthe
retention ratio and the return on equity.
Algebraic manipulation can allowus to statethe retention
ratioasafunctionoftheexpectedgrowthrateandreturnon
equity: