Introduction to Corporate Finance

10: Cash Flow and Capital Budgeting

in assessing an investment’s merit. Analysts must think very carefully about the assumptions they make

when calculating terminal value.

For example, the growth rate used to calculate a project’s terminal value does not always equal

the long-run growth rate of the economy. A factory with fixed capacity might offer zero growth

in cash flows, or growth that just keeps pace with inflation, once the company hits the capacity

constraint.

Several other methods maintain widespread application in terminal-value calculations. One method

calculates terminal value by multiplying the final year’s cash flow estimate by a market multiple such as

a price-to-cash-flow ratio (price-to-earnings and price-to-sales ratios are also used at times) for publicly

traded companies with characteristics similar to those of the investment. For example, the last specific

cash flow estimate for the Tribor Pty Ltd acquisition was $3.25 billion in year 5. Nvigor8 Ltd may observe

that the average price-to-cash-flow ratio for companies in this industry is 20. Multiplying $3.25 billion

by 20 results in a terminal value estimate of $65 billion, quite close to the estimate obtained from the

perpetual growth model. One hazard in using this approach is that market multiples fluctuate through

time, which means that when year 5 finally arrives, even if Tribor Pty Ltd generates $3.25 billion in cash

flow as anticipated, the market may place a much lower value on that cash flow than it did when the

acquisition originally took place.

Other approaches to this problem use an investment’s book value or its expected liquidation value

to estimate the terminal-value figure. Using book value is most common when the investment involves

physical plant and equipment with a limited useful life. In such a case, companies may plausibly assume

that after a number of years of depreciation deductions, the asset’s book value will be zero. Depending

on whether the asset has fairly standard characteristics that would enable other companies to use it,

its liquidation value may be positive or it may be zero.^7 Finding a liquidation value often involves the

inclusion of the tax cash flows that result from selling the asset for a price that differs from its book

value at the time of sale. Some assets may even have negative terminal values if disposing of them

entails substantial costs. Projects that involve the use of substances hazardous to the environment fit this

description. When an investment has a fixed life span, part of the terminal value or terminal cash flow

may also include recovery of working capital investments. When a retail store closes, for example, the

company realises a cash inflow from liquidating inventory.

1 Why is it important for the financial analyst to: (a) focus on incremental cash flows; (b) ignore

financing costs; (c) consider taxes; and (d) adjust for non-cash expenses when estimating a project’s

relevant cash flows?

2 Why do we consider changes in net working capital associated with a project to be cash inflows or

outflows rather than consider the absolute level of net working capital?

3 For what kinds of investments does terminal value account for a substantial fraction of the total

project NPV, and for what kinds of investments is terminal value relatively unimportant?

CONCEPT REVIEW QUESTIONS 10-1

7 Anecdotal evidence suggests that companies can expect to recover no more than 20–50% of the original purchase cost of a new machine,
once it has been installed. This finding is applicable even for assets with reasonably active secondary markets.