Terminal value of any security is defined as the present value of the future cash flows of that security at a particular time in the future when stable growth is expected forever. Terminal Value can be calculated using the Stable growth method using the formula:
Terminal Value = (Free Cash Flown × (1 + g)) / (WACC - g)
WACC = Weighted Average Cost of Capital
g = Constant Growth Rate
The above formula assumes that the cash flow of the firm will grow at a constant growth rate forever. It is used in discounted cash flow analysis, budget planning and evaluation of potential gain of an investment over a specified time period. Discount Rate can be used instead of WACC.
To find the present value of the Terminal Value, it is discounted by the number of years included in the projection. The present value of the Terminal value is then added by the present value of the free cash flows in the projection period to calculate the Net Present Value.
Example:
Let the normalized free cash flow be $25,000. The expected growth rate after the forecast period is 5% and the WACC of the company is 8%. The Terminal Value is hence calculated as :
TV = ($25,000 × 1.05) / (0.08 – 0.05) = $875,000
Terminal Value is also calculated using the Adjusted Growth method by the formula as:
TV = EBIT (1 – Tax Rate) (1-g / r) / (WACC – g)
EBIT = Earnings before Interest and Tax
g = growth rate
r = rate of return on new investments
WACC = Weighted Average Cost of Capital
Hence, this concludes the definition of Terminal Value along with its overview.
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