Answer 11

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Read more on excess returns in terminal value

One of the easiest ways to increase your value is to nudge up your stable growth rate towards your cost of capital. At first sight, therefore, it looks like increasing the stable growth rate will always increase terminal value. However, this is only true if you are internally inconsistent in your assumptions. If you estimate the reinvestment rate as a function of your expected growth and return on capital, you set up a trade off:

Reinvestment rate = Stable growth rate/ Return on capital

The trade off is as follows. If you increase the stable growth rate, the reinvestment rate will go up. Thus, while you gain from growth, you will lose in cashflows:

Terminal value = EBIT (1-t) (1 - Reinvestment rate)/ (Cost of capital -g)

In the special case where you assume that the return on capital is equal to your cost of capital, your gain from increasing growth will exactly be offset by the loss from having a higher reinvestment rate, nullifying the effect of growth. In that case, the terminal value will always be

Terminal value = EBIT (1-t) / Cost of capital

If you assume that the firm will earn more than its cost of capital in perpetuity, increasing growth will increase value. If you assume that it will earn less than its cost of capital in perpetuity, increasing growth will reduce terminal value.


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