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Terminal Value

The terminal value is the present value of abnormal earnings or free cash flows expected beyond the forecast period, usually 5-10 years. This value represents the remaining lifetime value of the firm. Simplifying assumptions are made to estimate terminal value through formulas rather than explicit long-term forecasts. A popular approach is to capitalize the last period's abnormal earnings or cash flows by the inverse of the cost of capital. The appropriate discount rate to use is the weighted average cost of capital (WACC), which considers the firm's debt and equity sources of financing. The WACC can be estimated using the capital asset pricing model (CAPM) to calculate the cost of equity.

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67 views

Terminal Value

The terminal value is the present value of abnormal earnings or free cash flows expected beyond the forecast period, usually 5-10 years. This value represents the remaining lifetime value of the firm. Simplifying assumptions are made to estimate terminal value through formulas rather than explicit long-term forecasts. A popular approach is to capitalize the last period's abnormal earnings or cash flows by the inverse of the cost of capital. The appropriate discount rate to use is the weighted average cost of capital (WACC), which considers the firm's debt and equity sources of financing. The WACC can be estimated using the capital asset pricing model (CAPM) to calculate the cost of equity.

Uploaded by

Ousman
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© © All Rights Reserved
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Download as DOCX, PDF, TXT or read online on Scribd
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Terminal Value

The terminal value is the final year of the forecast and represents the PV of future of abnormal
earnings or free cash flows for the remainder of the firm’s life. Terminal value is then the present
value of either abnormal earnings or free cash flows occurring beyond the terminal year. Since
this involves forecasting performance over the remainder of the firm’s life, the analyst must
adopt some assumption that simplifies the process of forecasting.

Selecting the terminal year; five- to ten-year forecast horizon should suffice for most firms. A
five- to ten-year forecast horizon should be more than sufficient for most firms. Exceptions
would include firms so well insulated from competition (perhaps due to the power of a brand
name) that they can extend their investment base to new markets for many years and still expect
to generate supernormal returns.

Making simplifying assumptions about the company’s performance during this period allows us
to estimate terminal value by using formulas instead of explicitly forecasting and discounting
cash flows over an extended period.

A popular approach to terminal value calculation is to apply a multiple to abnormal earnings,


cash flows, or book values of the terminal period. The approach is not as ad hoc as it might first
appear. Note that under the assumption of no sales growth, abnormal earnings or cash flows
beyond the terminal year remain constant. Capitalizing these flows in perpetuity by dividing by
the cost of capital is equivalent to multiplying them by the inverse of the cost of capital.

Computing a Discount Rate

To value a company’s equity, the analyst discounts abnormal earnings or cash flows available to
equity holders using the cost of equity, which is the return required by equity investors. One
common approach is to use the capital asset pricing model (CAPM), which expresses the cost of
equity as the sum of a required return on riskless assets plus a premium for beta or systematic
risk:

Cost of equity = Riskless rate of return + (Beta risk x Market risk premium)

Although the CAPM is often used to estimate the cost of equity, evidence indicates that the
model is incomplete. Assuming stocks are priced competitively, stock returns should be expected
just to compensate investors for the cost of their capital. Thus long-run average returns should be
close to the cost of equity and should (according to the CAPM) vary across stocks according to
their systematic risk. However, factors beyond just systematic risk seem to play some role in
explaining variation in long-run average returns. The most important such factor is labeled the
“size effect”: smaller firms (as measured by market capitalization) tend to generate higher
returns in subsequent periods.
- The appropriate discount rate is the WACC, which takes into account debt and equity
sources of financing.
- WACC = % debt financing1 * After-tax cost of debt + % equity financing * Cost of
equity capital = When calculated debt: Use from as discount rate in public treated
security Should use -Long term bonds consider the life of whole company-Liquid bonds
public treated in the market.

Adjusting Cost of Equity for Changes in Leverage

The change in the cost of debt can be estimated by examining the cost of debt for firms in the
same or comparable industries that have the revised capital structure. The change in the cost of
equity can be estimated by computing the beta of the firm’s assets, that is, the weighted average
beta risk of its debt and equity, and then re-levering the firm using its new capital structure. The
first step in this process is to infer the old and revised debt betas using the capital asset pricing
model and given information on the former and revised costs of debt, the risk premium, and the
risk-free rate. To compute the revised cost of debt, the analyst can estimate how the revised
capital structure would change its debt rating (as discussed in Chapter 10). Higher or lower rated
debt would increase or decrease the firm’s cost of debt.

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