100
Free Cash Flow
Growth rate
Tax Rate
Cost of Capital
Debt-to-total value
50%
Given the data in the above table, what is the
terminal value of the business (using the growing
perpetuity formula)?
3000
3400
3366
3600
Answers
Answer:
Terminal value is the estimated value of a business beyond the explicit forecast period. It is a critical part of the financial model, as it typically makes up a large percentage of the total value of a business. There are two approaches to the DCF terminal value formula: (1) perpetual growth, and (2) exit multiple.
Explanation:
Why is a Terminal Value Used?
When building a Discounted Cash Flow / DCF model there are two major components: (1) the forecast period and (2) the terminal value.
The forecast period is typically 3-5 years for a normal business (but can be much longer in some types of businesses, such as oil and gas or mining) because this is a reasonable amount of time to make detailed assumptions. Anything beyond that becomes a real guessing game, which is where the terminal value comes in.
What is the Perpetual Growth DCF Terminal Value Formula?
The perpetual growth method of calculating a terminal value formula is the preferred method among academics as it has the mathematical theory behind it. This method assumes the business will continue to generate Free Cash Flow (FCF) at a normalized state forever (perpetuity).
The formula for calculating the perpetual growth terminal value is:
TV = (FCFn x (1 + g)) / (WACC – g)
Where:
TV = terminal value
FCF = free cash flow
n = year 1 of terminal period or final year
g = perpetual growth rate of FCF
WACC = weighted average cost of capital
What is the Exit Multiple DCF Terminal Value Formula?
The exit multiple approach assumes the business is sold for a multiple of some metric (e.g., EBITDA) based on currently observed comparable trading multiples for similar businesses.
The formula for calculating the exit multiple terminal value is:
TV = Financial Metric (e.g., EBITDA) x Trading Multiple (e.g., 10x)