to reinvestat thespecified returnoncapital. Growthfrom
existingassetscanoccuronlyintheshortterm,sincethereis
a limit to how efficiently you can utilize existing assets.
3.Lengthoftheextraordinarygrowthperiod.Giventhatwe
cannot estimate cash flows forever, we generally impose
closure in valuation models by assuming that cash flows,
beyondtheterminalyear,willgrowataconstantrateforever,
whichallowsustoestimatetheterminalvalue.Thus,inevery
discounted cash flow valuation, there are two critical
assumptions we need to make on stable growth. Thefirst
relatestowhenthefirmthatwearevaluingwillbecomea
stable-growthfirm,ifitisnotonealready.Theanswertothis
question will depend in large part on the magnitude and
sustainabilityofthecompetitiveadvantagespossessedbythe
firm.Thesecondrelatestowhatthecharacteristicsofthefirm
willbeinstablegrowth,intermsofreturnoncapitalandcost
of capital. Stable-growth firms generally have small or
negligible excess returns and are of average risk.
- Cost of capital. The expected cash flows need to be
discountedbackata ratethatreflectsthecostoffinancing
theseassets.RecappingthediscussioninChapter2,thecost
ofcapitalis acomposite costof financingthatreflects the
costsofbothdebtandequity,andtheirrelativeweightsinthe
financingstructure.Thecostofequityrepresentstherateof
returnrequiredbyequityinvestorsinthefirm,andthecostof
debtmeasuresthecurrentcostofborrowing,adjustedforthe
taxbenefits ofborrowing.A firm’scost of capitalwillbe
determinedbythemixofdebtandequityitchoosestouse,
andwhetherthedebtreflectstheassetsofthefirm;long-term
assetsshouldbefundedwithlong-termdebtand short-term
assetsbyshort-termdebt.Usingasuboptimalmixofdebtand