SuperiorCo earns a return on invested capital of 20 percent on its existing stor

Question

SuperiorCo earns a return on invested capital of 20 percent on its existing stores. Given intense competition for new stores sites, you believe new stores will only earn their cost of capital. Consequently, you set return on new capital (8 percent) equal to the cost of capital (8 percent) in the continuing value formula. A colleague argues that this is too conservative, as SuperiorCo will create value well beyond the forecast period. In no less than 5 sentences, what is the flaw in your colleague's arguement?

Explanation / Answer

Flaw in colleague's argument is that he is not seeking the wealth and savings beyond cost of capital as by introducing 8% return on new capital we could earn on additional contributed capital.

As when we will introduce it to continuing valu formula:

Free cash flow*(1+g)/WACC-g

then this will make denominator zero and hence terminal value can be moved to infinity.!!

Please do rate my answer with 5 star ratings.!!

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