MN AS earns a roic of 25% on its existing stores. Given high competition for new

Question

MN AS earns a roic of 25% on its existing stores. Given high competition for new store sites, you belive new stores will only earn their cost of capital. Consequently, you set return on new capital (10 %) equal to the cost of capital (10 %) in the terminal value formula. A colleague argues that this is too conservative, as MN AS will create value well beyond the forecast period. What is the flaw in your colleague’s argument? When do we create value? What is a measure commonly used for the value created in this context?  

Explanation / Answer

The colleague believes that MN AS will create value well beyond the forecast period without considering the fact that the Terminal Value is, in fact, an approximation of the value created by the company well beyond the forecast horizon. If the terminal value formula considers the return on capital to be equal to the firm's cost of capital it essentially means that return gets restricted to this value for perpetuity (considering the firm is a going concern). This would imply that all new stores would generate returns equal to the cost of capital into perpetuity, thereby creating expected value at a lower conservative rate of 10%.

Further, a company generates positive value for itself only when the cost of capital of the firm (cost incurred to source capital) is lower than the return generated on these capital employed. If the firm's returns (inflow) is lower than its cost(outflow), then the firm would generate negative value or in other words, the firm would see capital erosion.

The value created by consistently generating returns on capital above the cost of capital is known as the sustainable growth in the firm's value.

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