Which component is essential for calculating terminal value in DCF?

Which component is essential for calculating terminal value in DCF?

• A. Current cash balance
• B. Projected cash flows
• C. Total equity
• D. Company's current debt

Answer: (B)

To calculate terminal value in a Discounted Cash Flow (DCF) analysis, the essential component is projected cash flows. The terminal value represents the present value of all future free cash flows beyond a certain projection period and into perpetuity. It reflects the value of the business at the end of the explicit forecast period. Projected cash flows are critical because they serve as the foundation for estimating the future performance of the company. The two most common methods for determining terminal value are the Gordon Growth Model (also known as the perpetual growth model) and the exit multiple method. Both methods require an understanding of the company's expected cash flows following the explicit forecast period. In the Gordon Growth Model, for example, the terminal value is calculated using the formula: \[ \text{Terminal Value} = \frac{\text{FCF} \times (1 + g)}{r - g} \] Where FCF is the free cash flow in the last forecasted period, g is the growth rate beyond that period, and r is the discount rate. This clearly showcases how projected cash flows are pivotal to determining terminal value. Other components, such as current cash balance, total equity, and current debt, do not directly influence the calculation of terminal value, even though

To calculate terminal value in a Discounted Cash Flow (DCF) analysis, the essential component is projected cash flows. The terminal value represents the present value of all future free cash flows beyond a certain projection period and into perpetuity. It reflects the value of the business at the end of the explicit forecast period.

Projected cash flows are critical because they serve as the foundation for estimating the future performance of the company. The two most common methods for determining terminal value are the Gordon Growth Model (also known as the perpetual growth model) and the exit multiple method. Both methods require an understanding of the company's expected cash flows following the explicit forecast period.

In the Gordon Growth Model, for example, the terminal value is calculated using the formula:

[ \text{Terminal Value} = \frac{\text{FCF} \times (1 + g)}{r - g} ]

Where FCF is the free cash flow in the last forecasted period, g is the growth rate beyond that period, and r is the discount rate. This clearly showcases how projected cash flows are pivotal to determining terminal value.

Other components, such as current cash balance, total equity, and current debt, do not directly influence the calculation of terminal value, even though