Firm Valuation and Leverage

A standard critique of the use of cost of capital in firm valuation is that it assumes that leverage stays stable over time (through the weights in the cost of capital). Is this true?

a. Yes b. No wacc.xls: This dataset summarizes the costs of capital for firms in the United States, categorized by industry group.

c. Estimating Terminal Value

The approach most consistent with a discounted cash flow model assumes that cash flows, beyond the terminal year, will grow at a constant rate forever, in which case the terminal value can be estimated as follows:

Terminal valuen = Free Cashflow to Firmn+1 / (Cost of Capitaln+1 - gn) where the cost of capital and the growth rate in the model are sustainable forever. We can use the relationship between growth and reinvestment rates that we noted earlier to estimate the reinvestment rate in stable growth:

Reinvestment Rate in stable growth = Stable growth rate / ROCn where the ROCn is the return on capital that the firm can sustain in stable growth. This reinvestment rate can then be used to generate the free cash flow to the firm in the first year of stable growth:

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