afunctionofexpectedgrowth,thefreecashflowtothefirm
can be inflated (deflated) by reducing (increasing) capital
expendituresrelativetodepreciation.Ifthereinvestmentrate
isestimatedfromthereturnoncapital,changesinthereturn
on capital can have significant effects on firm value.
ILLUSTRATION6.1:ValuingaFirmwithaStableGrowth
FCFF Model: Nintendo
Nintendowasapioneerinthevideogamingbusinesswithits
proprietary Nintendo consoles and games. As the video
gaming market grew, itattracted intense competition from
SonyandMicrosoft.Thesecash-richgiantsintroducedtheir
own proprietary formats (Sony with PlayStation and
MicrosoftwithXbox),puttingpressureonNintendotoupdate
its system. In 2004, Nintendo reported pretax operating
income of 99.55 billion yen, translating into an after-tax
returnoncapitalof8.54%,basedoncapitalinvestedatthe
startof 2004 (based on a33% taxrate). Theconservative
managementatthefirmhasnotreinvestedmuchbackintothe
business,resultinginareinvestmentrateofonly5%overthe
pastfewyears.Ifweassumethatthesenumbersholdforthe
longterm, theexpectedgrowthratein operatingincome is
0.427%:
To value the firm using this stable growth rate, we first
estimate the free cash flow to the firm next year: