Terminal Value

In a typical multi-year DCF valuation, why is the analysis particularly sensitive to the terminal value assumption?

1. A.Because the terminal value is usually a small share of total value, so any error there is dilutedWrong. The opposite is true — terminal value is usually the larger share of total DCF value, which is exactly why it is so sensitive.
2. B.Because the terminal value typically represents the majority of total implied value, so small assumption changes move the result significantlyCorrect. This is precisely why the terminal growth rate and WACC used deserve careful scrutiny in a DCF.
3. C.Because FINRA requires the terminal value to be computed using a fixed 5% growth rateWrong. No such fixed regulatory growth rate exists; terminal growth is an analytical assumption.
4. D.Because terminal value is unaffected by the choice of discount rateWrong. Terminal value is discounted using WACC and is highly sensitive to it, especially given the (WACC − g) denominator.

Why: The terminal value — capturing all cash flows beyond the explicit projection period — commonly represents a large majority of a DCF's total implied value, so small changes in the terminal growth rate or WACC used in the terminal value formula can swing the overall valuation dramatically.

Halworth Systems' final projected free cash flow is $50 million, expected to grow at a 3% terminal growth rate forever thereafter. Using a 9.2% WACC, what is the terminal value (using the Gordon growth / perpetuity growth model)?

1. A.$806.5 millionWrong. This uses $50M directly instead of growing it by (1 + g) first ($50M ÷ 0.062).
2. B.$830.6 millionCorrect. $50M × 1.03 ÷ 0.062 ≈ $830.6 million.
3. C.$1,612.9 millionWrong. This divides by (WACC − g) using a WACC or growth rate different from the ones given.
4. D.$538.6 millionWrong. This does not correctly apply the perpetuity growth formula to the given inputs.

Why: Terminal Value = Final Year FCF × (1 + g) ÷ (WACC − g) = $50M × 1.03 ÷ (0.092 − 0.03) = $51.5M ÷ 0.062 ≈ $830.6 million.

A simplified two-year DCF for fictional Halworth Systems has: Year 1 FCF of $40 million with present value of $36.6 million, and Year 2 FCF of $50 million with present value of $41.9 million. The present value of the terminal value (computed separately) is $658 million. What is the implied enterprise value?

1. A.$78.5 millionWrong. This sums only the two explicit-period present values and omits the terminal value entirely.
2. B.$658 millionWrong. This is only the present value of the terminal value, omitting the explicit-period cash flows.
3. C.$736.5 millionCorrect. $36.6M + $41.9M + $658M = $736.5 million.
4. D.$90 millionWrong. This sums the undiscounted Year 1 and Year 2 FCF figures, ignoring both discounting and the terminal value.

Why: Implied EV = sum of the present values of all explicit-period free cash flows plus the present value of the terminal value = $36.6M + $41.9M + $658M = $736.5 million.

In building a DCF terminal value using the perpetuity growth (Gordon growth) model, the terminal growth rate assumed must be:

1. A.Higher than the growth rate used in the explicit projection periodWrong. Terminal growth is typically set lower than near-term explicit growth, reflecting a mature, steady-state pace — not higher.
2. B.Exactly equal to the WACC used to discount the terminal valueWrong. That would make the denominator (WACC − g) zero, producing an undefined result.
3. C.Always set at exactly 0%, representing no growthWrong. Terminal growth can be any rate below WACC, including a modest positive rate reflecting long-run inflation or GDP growth; it need not be zero.
4. D.Strictly less than the WACC used to discount the terminal valueCorrect. If g equals or exceeds WACC, the (WACC − g) denominator is zero or negative, breaking the formula.

Why: The perpetuity growth formula divides by (WACC − g). If the terminal growth rate g is set equal to or above WACC, the denominator becomes zero or negative, producing an undefined or nonsensical (negative) terminal value — so g must be strictly less than WACC for the formula to produce a meaningful result.