a.
Can you
use the same equation to compute growth in operating income?
No. When computing growth in operating
income, the equation is slightly different:
Expected growth in operating income
= {(Cap ex  Depreciation + Change in noncash Working capital)/
Aftertax Operating Income}* Return on capital
Return on capital = Aftertax Operating
Income/ (Book value of debt + Book value of equity)
You have to be consistent. When talking
about firm value, every input has to be stated in terms of firm
value. Thus, in the above equation the retention ratio (which
measures reinvestment as a percent of equity income) is replaced
by the reinvestment rate (which measures reinvestment as a percent
of aftertax operating income) and the return on equity (which
is the net income divided by book equity) is replaced by the
return on capital (which measures the total return to all investment).
b.
Under what
assumptions will this sustainable growth rate also be equal to
your expected growth rate?
These equations hold only if the
return on equity and capital on existing assets remain unchanged
over time. If the return on equity or capital is expected to
change over time, there will be a second component to the expected
growth rate equation. For instance, assume that your return on
capital this year is 10% and that you expect it to improve to
12% next year on exiting assets and that you plan to reinvest
50% of your operating income back next year into new projects
on which you expect to make 12%.
Expected growth next year = (.50)
(.12) + (.12.10)/.12 = 26%
You can decompose this growth into
2 parts  growth from new investments (6%) and growth from more
efficient use of existing investments (20%). The problem with
depending upon the latter is that it is a finite source of growth.
At some point in time, your assets will be optimally utilized
and you will no longer be able to extract additional growth.
That is why you cannot count on the latter in perpetual growth
(terminal value).
 Increasing
the amount you reinvest back into the business (reduce the
payout ratio or increase the reinvestment rate) will increase
the growth rate for any company that is prfitable. Will it
also increase value?
No. It depends upon whether the return
on capital (equity) is greater that the cost of capital (equity).
If the return on capital is less than the cost of capital, increasing
the reinvestment rate will increase growth but reduce value. If
it is equal, increasing reinvestment will not affect value. It
is growth with excess returns that is the source of value.
