thereinvestmentrateusedtoestimatefreecashflowstothe
firmshouldbeconsistentwiththestablegrowthrate.Thebest
waytoenforcethisconsistencyistoderivethereinvestment
ratefromthestablegrowthrateandthereturnoncapitalthat
the firm can maintain in perpetuity.
Ifreinvestmentisestimatedfromnetcapitalexpendituresand
changeinworkingcapital,thenetcapitalexpendituresshould
be similarto those otherfirmsin theindustry (perhaps by
setting the ratio of capital expenditures to depreciation at
industryaverages)andthechangeinworkingcapitalshould
generally not be negative. A negative change in working
capitalcreatesacashinflow,andwhilethismay,infact,be
viableforafirmintheshortterm,itisdangeroustoassumeit
in perpetuity.
1 The cost of capital should also be reflective of a
stable-growthfirm.Inparticular,thebetashouldbecloseto
1—theruleofthumbpresentedintheearlierchaptersthatthe
beta should be between 0.8 and 1.2 still holds. While
stable-growth firms tend to use more debt, this is not a
prerequisite for themodel, sincedebt policy is subject to
managerial discretion.
Like all stable-growth models, this one is sensitive to
assumptions about the expected growth rate. This is
accentuated,however,bythefactthatthediscountrateused
invaluationistheWACC,whichissignificantlylowerthan
thecostofequityformostfirms.Furthermore,themodelis
sensitive to assumptions made about capital expenditures
relativetodepreciation.Iftheinputsforreinvestmentarenot