SuperiorCo earns a return on invested capital of 20% on its existing stores. Given intense...

Question:

SuperiorCo earns a return on invested capital of 20% 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%) equal to the cost of capital (8%) in the continuing value formula. A colleague argues that this is too conservative, as SuperiorCo will create value well beyond the forecast period. What is the flaw in your colleague's arguement?

Cost Of Capital:

The cost of capital is the cost of using internal and external money to support the business operation. The cost of capital is expected to be lower than the ROI.

Answer and Explanation:

In this case, the colleague believes that SuperiorCo will perform beyond the forecasting. This belief might be true to the entire SuperiorCo, but it is impossible to confirm that a new store will follow the entire firm's performance since the new store is under intense competition. In addition, the new store's return cannot be compared with the existing stores. The return on new capital,8%, is set for the new store, which is based on its cost of capital. Thus, it is not realistic to use the expected return for the entire firm for a store. Moreover, the cost of capital to run the new store might be different from the firm's cost of capital.


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Required Return vs. Cost of Capital

from Finance 101: Principles of Finance

Chapter 14 / Lesson 1
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