Terminal Value Understanding Perpetual Cash Flow Projections in DCF Model

  1. Financial Modelling
    1. Financial Modelling Introduction
    2. Financial Modelling Tools & steps
    3. How to Make a Financial Model and choose the best Company and Excel Workbook Setup?
    4. How to build a financial model Step-by-Step Guide to Excel Sheet Setup?
    5. Financial Statements: A Step-by-Step Guide to Extracting Historical Data
    6. Financial modelling excel
    7. Learn financial modelling Balance Sheets, P&L, and Assumptions Know About
    8. What is financial modelling Assumptions and Projections?
    9. Financial modelling and valuation
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    11. The balance sheet’s asset side reveals the company’s line items.
    12. Revenue Model & Growth Rate in in P&L Assumptions
    13. Basics of financial modelling CAPEX and Asset Schedule
    14. Financial Analysis: Gross Block and CAPEX
    15. Gross block & Capex: Constructing the Asset Schedule
    16. Depreciation : Connecting P&L and Balance Sheet for Accurate Asset Forecasting
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    21. IPOs and Under subscription : Bata’s Share Capital Dynamics
    22. Reserves & Surplus understanding Bata schedule
    23. Reserves and surplus schedule How to Build on Excel
    24. Financial modelling projections
    25. Balance Sheet Projections and Completing Reserves Schedule
    26. Cash Flow Statements Analysing Operations, Investments, and Financing Activities
    27. What Is Valuation for Investor
    28. Free Cash Flow Key Components, Formulas and How to Calculate?
    29. FCFF and FCFE uses in Mastering Free Cash Flow Calculation
    30. WACC Weighted Average Cost of Capital Analysis
    31. Market Risk Premium analysis
    32. Tax Shield and its Impact on Equity Holder Returns
    33. Weighted Average Cost of Capital and Terminal Growth in Valuation
    34. Terminal Value Understanding Perpetual Cash Flow Projections in DCF Model
    35. Learn Financial Modelling
    36. Free Cash Flow to the Firm (FCFF) Calculation with examples
    37. Stock Valuation DCF Model & Stock Market Value
Marketopedia / Financial Modelling / Terminal Value Understanding Perpetual Cash Flow Projections in DCF Model

We invest in a company in the hope of generating wealth. This is not a quick process but takes place over numerous years. We must accept that this firm is, hypothetically, a continuing venture. Even though I’m not personally fond of the assumption, the discounted cash flow model assumes that it will exist indefinitely.

Let us assume this is true for now.

We can project cash flow for the next five years but also anticipate that the company will exist for much longer, so there would be a continuous cash flow timeline.

When we project the cash generated over the next five years, we consider a specific growth rate. To account for future earnings, we must apply a similar growth rate beyond year five into perpetuity.

The growth rate is referred to as ‘The terminal value growth rate’, which usually matches the long-term inflation rate. Did you notice this so far?

For the initial five years of our model, we conduct a comprehensive evaluation of the cash flow.

Once we reach the fifth year, it is no longer necessary to conduct a detailed analysis; rather, we can simply assume cash flow to increase in perpetuity (terminal value).

The underlying presumption is that the cash flow beginning in the 5th year will remain constant and yield a positive outcome. If the cash flows are negative, discounted cash flow analysis will be ineffective.

Once we have the terminal value growth rate, equal to the long-term inflation of the country, we can compute the present value of each future cash flow by applying a discount rate. This rate could be either the return expectation of equity investors or that of the firm (WACC). To calculate the present value of infinite future cash flows, however, we cannot use the standard present value formula. Consequently, a specific formula needs to be used in this case –

Present value of Terminal Value = C (1+ g)/(r-g)

Where –

C = cash as of today

g = growth rate, i.e. inflation rate

r = discount rate (either for equity investors or the firm as such)

We won’t go into the details of how to derive the formula right now. However, let us consider what we are attempting to accomplish. Starting from year five and afterwards, in perpetuity, let’s look at the cashflow.

6th Year – FCF is 50Cr

7th Year – FCF is 53 Cr

8th Year – FCF is 55 Cr

You essentially calculate the lump sum amount you must pay today, in order to receive a stream of cash flow in the future. This calculation continues infinitely.

I hope you understand what we have been trying to discuss. If anything is still unclear, feel free to re-read this chapter. We will then move on to the next step and put all our knowledge into practice with a complete valuation model.

The DCF model is very reactive to changes in the terminal value due to its sheer magnitude. The effects of these alterations will be clearly evidenced in the following chapter.