Introduction to Corporate Finance

PArT 3: CAPITAL BUDGETING

For example, in valuing a large acquisition, many acquiring companies project the target company’s cash

flows for five to 10 years in the future. After that, they assume that cash flows will grow at a rate equal to

the growth rate in gross domestic product (GDP) for the economy.^5

example

Suppose that analysts at Nvigor8 Ltd are analysing the

potential acquisition of Tribor Pty Ltd. They project

that the acquisition of Tribor Pty Ltd will generate the

following new stream of cash flows:

Year 1 $0.50 billion

Year 2 1.00 billion

Year 3 1.75 billion

Year 4 2.50 billion

Year 5 3.25 billion

In year 6 and beyond, analysts believe that cash

flows will continue to grow at 5% per year. What

is the terminal value of this investment? Recall that in

chapters 3 and 5, we learned that we can determine

the present value, at a discount rate rt, of a stream of

cash flows growing at a perpetual rate, g, by using the

following formula:

PVt =

CF

rg

t 1

−

+

We know that the year 6 cash flow is 5% more

than in year 5, or $3.4125 billion (1.05 × $3.25 billion).

Put that number in the numerator of the equation.

We also know that g = 5%. Suppose that Nvigor8 Ltd

discounted the cash flows of this investment at 10%.

Using the formula above, we can determine that the

present value, as of year 5, of cash flows in years 6 and

beyond equals the following:

PV 5 = $3.4125

0.10 0.05

$68.25

−

=

example

This means that the terminal value, the value of the project at the end of year 5, equals $68.25 billion. To

determine the entire value of the project, discount this figure, along with all the other cash flows, at 10% to

obtain a total value of $48.70 billion:^6

$0. 5

1.10

$1

1.10

$1.75

1.10

$2. 5

1.10

$3.25

1.10

$68.25

1.10

12 ++ 34 ++ 55 +=$48.70

Given this set of assumptions, the most Nvigor8 Ltd should pay to acquire Tribor Pty Ltd is about $48.70

billion. Notice that the terminal value is enormous relative to the cash flows that occur in years 1 through 5.

This highlights the fact that accurately estimating terminal value is very important.

Notice in the preceding example that the terminal value was very large relative to all the other cash

flows. If we discount the terminal value for five years at 10%, we find that $42.38 billion of the project’s

total $48.70 billion present value comes from the terminal-value assumptions. Those proportions are not

uncommon for long-lived investments, illustrating just how important estimates of terminal value can be

How far out into the future

do companies take financial

projections for major

investments?

thinking cap
question

5 We emphasise that when companies assume that an investment’s cash flows will grow at some rate in perpetuity, the rate of growth in

nominal GDP, either in the local economy or the world economy, serves as a maximum potential long-run growth rate. Why? If an investment

generates cash flows that grow forever at a rate that exceeds the growth of nominal GDP, then mathematically, that one investment

eventually becomes the entire economy.

6 Notice that this is the gross present value, not the NPV, because in this example we are not deducting any up-front costs incurred to acquire

Tribor Pty Ltd.