Advanced Financial Management · Valuation and the use of free cash flows

Estimating Growth Rates and Forecast Cash Flows for ACCA AFM

Updated 11 October 2026 · Fact-checked

Growth in cash flow comes from reinvestment. Estimate it as g = reinvestment rate × return on investment (b × r). Then forecast free cash flows year by year over an explicit period, and apply a steady-state growth rate to a terminal value. Discount everything at the right rate to value the business.

Understand Estimating Growth Rates and Forecast Cash Flows

A business grows only if it puts money back in. If it pays out all its profit, there is nothing new to earn on, so growth is nil. The more it retains and the higher the return it earns on what it retains, the faster profits and cash flows grow.

That gives the core link: growth = reinvestment rate × return on investment. In the dividend model this is Gordon's growth: g = b × r, where b is the proportion of earnings retained and r is the return on new equity investment. The same logic applies to free cash flow: reinvestment is the money put into capital expenditure above depreciation and into working capital.

Historical growth is a second source. You can take the average annual growth in past dividends or earnings. Use it with care. It assumes the past repeats, and it may be distorted by one-off items or by a different mix of retention and returns.

A valuation usually splits the future in two. In the explicit forecast period (often 3 to 5 years) you forecast each year's cash flow, because growth may be high or uneven. After that comes the steady state, where cash flows grow at a constant, sustainable rate forever. You value that with a growing perpetuity formula and discount it back. Steady-state growth cannot sensibly exceed long-run growth in the economy, because no firm can outgrow it forever.

In AFM you must also say whether the numbers are sensible. Comment on whether the assumed return is achievable, whether inflation is treated consistently, and how sensitive the value is to g.

Key rules to remember

Sustainable growth (Gordon's growth approximation): g = b × r; b = retention (reinvestment) rate, r = return on new investment, often ROE. Assumes r stays constant and the capital structure is unchanged.
Retention rate: b = 1 − (dividend ÷ earnings) = 1 − payout ratio; For free cash flow, reinvestment rate = net reinvestment ÷ after-tax operating profit.
Reinvestment rate for FCFF: Reinvestment rate = (Capex − Depreciation + Increase in working capital) ÷ NOPAT; NOPAT = operating profit × (1 − tax rate).
Growth in FCFF: g = Reinvestment rate × ROIC; ROIC = NOPAT ÷ invested capital. Use the return expected on new investment.
Historical growth rate: g = (Latest ÷ Earliest)^(1 ÷ n) − 1; n = number of years of growth between the two figures, not the number of figures.
Forecast cash flow: CF(t) = CF(0) × (1 + g)^t; Use different g values for different years if the question gives them.
Terminal value (growing perpetuity): TV at end of year n = CF(n+1) ÷ (k − g) = CF(n) × (1 + g) ÷ (k − g); Needs k > g. Discount TV by the year-n discount factor.

How to solve Estimating Growth Rates and Forecast Cash Flows questions

Use this method for any question that asks you to estimate growth or forecast cash flows for a valuation.

1Identify what is being valued (equity using FCFE or dividends, or the firm using FCFF) and match the discount rate: cost of equity for FCFE, WACC for FCFF.
2Find the growth rate. If you are given retention and return, use g = b × r. If you are given past figures, compute the compound growth rate. If the question gives g, use it.
3Check the inputs. Confirm that b is retention not payout, that r is the return on new investment, and that all rates are in the same units.
4Forecast the cash flows for each year of the explicit period, applying the growth rate (or rates) to the base figure. Adjust for tax, depreciation, capex and working capital as the question directs.
5Set the steady-state growth rate for after the explicit period. Calculate the first cash flow of the steady state and the terminal value with CF ÷ (k − g).
6Discount the explicit cash flows and the terminal value to present value. Add them to get the value, and deduct debt if you are valuing equity from FCFF.
7Comment. State the key assumptions, test the sensitivity to g and to the return, and say whether the growth is realistic.

Quickest way: Retention times return, then terminal value

When to use it: When time is short and the question gives retention (or payout) and a return figure, with a base cash flow or dividend.

Write g = b × r straight away. Convert payout to retention first.
Take the base figure and multiply by (1 + g) to get next year's cash flow.
Use value = next year's cash flow ÷ (k − g) for a constant-growth value.
If there is a high-growth period, list only those years, then add the terminal value discounted with the year-n factor.
Write one line of comment on whether g is realistic compared with long-run economic growth.

Common mistakes in Estimating Growth Rates and Forecast Cash Flows

Using the payout ratio instead of the retention rate in g = b × r.
Questions often give the dividend payout, and students plug it in directly.
Fix: Always compute b = 1 − payout first. Write it down as a separate line.
Forgetting to multiply by (1 + g) when using the growth perpetuity formula.
Students use the current cash flow as if it were next year's.
Fix: The formula needs the next cash flow: CF(0) × (1 + g) ÷ (k − g). Check which year the question's figure belongs to.
Discounting the terminal value at the wrong date.
The perpetuity formula gives a value one year before the first steady-state flow, which is easy to misplace.
Fix: If the first steady-state flow is in year n+1, the formula gives the value at the end of year n. Discount it with the year-n factor.
Using a growth rate equal to or higher than the discount rate.
A high g from b × r is accepted without checking.
Fix: Check k > g. If not, the model breaks down. Say that growth cannot persist and use a lower steady-state rate.
Computing historical growth with the wrong number of periods.
Students count the data points, not the intervals.
Fix: Five years of data give four growth periods. Use n = 4.
Mixing real and nominal figures, or equity and firm values.
Cash flows, growth and discount rates are taken from different parts of the question without checking consistency.
Fix: Use nominal flows with a nominal rate, or real with real. Use WACC with FCFF and cost of equity with FCFE.

Worked examples

Example 1

Dyer Ltd has earnings of $4 million this year and pays out 40% as dividends. It earns a return of 15% on new equity investment. The cost of equity is 12%. Estimate the growth rate and the value of Dyer's equity using the dividend growth model, assuming this year's dividend has just been paid.

Show the solution

Retention rate b = 1 − 0.40 = 0.60.
g = b × r = 0.60 × 15% = 9%.
Dividend just paid D0 = 40% × $4m = $1.6m.
D1 = $1.6m × 1.09 = $1.744m.
Value = D1 ÷ (ke − g) = $1.744m ÷ (0.12 − 0.09) = $1.744m ÷ 0.03 = $58.13m.

Answer: Growth is 9% a year and the equity is worth about $58.13 million. The value is very sensitive to g because ke − g is only 3%, so comment that small errors in g change the value a lot.

Example 2

Harlow plc has a free cash flow to the firm of $10 million for the year just ended. It expects FCFF to grow at 10% a year for the next 3 years and then at 4% a year for ever. WACC is 9%. Value the firm.

Show the solution

Year 1 FCFF = 10 × 1.10 = $11.000m.
Year 2 FCFF = 11.000 × 1.10 = $12.100m.
Year 3 FCFF = 12.100 × 1.10 = $13.310m.
Year 4 FCFF = 13.310 × 1.04 = $13.842m (rounded to 3 dp).
Terminal value at end of year 3 = 13.842 ÷ (0.09 − 0.04) = 13.842 ÷ 0.05 = $276.84m.
Discount factors at 9%: year 1 = 0.917, year 2 = 0.842, year 3 = 0.772.
PV of explicit flows = 11.000 × 0.917 + 12.100 × 0.842 + 13.310 × 0.772 = 10.087 + 10.188 + 10.275 = $30.55m.
PV of terminal value = 276.84 × 0.772 = $213.72m.
Firm value = 30.55 + 213.72 = $244.27m.

Answer: The value of the firm is about $244 million. About 87% of it comes from the terminal value, so the result depends heavily on the 4% steady-state growth assumption.

Exam tips

Show g = b × r as a separate line. Marks are often given for the method even if the data is later misused.
State your assumptions about the steady-state growth rate and why it is realistic. These are professional skills and commercial awareness marks.
Check the timing of the first cash flow before applying the perpetuity formula. Examiners test this often.
Comment on how much of the value comes from the terminal value and what that means for reliability.
Where the question gives both historical growth and b × r, compare them and explain which you would trust and why.

Practice questions from Valuation and the use of free cash flows

Estimating Growth Rates and Forecast Cash Flows in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CFA Level IIForecasting Free Cash Flow and Growth Rates

Estimating Growth Rates and Forecast Cash Flows: frequently asked questions

How do I estimate g from retention and ROE?

Multiply the retention rate by the return on new equity investment: g = b × r. Retention is 1 minus the payout ratio. The result assumes the return and the retention rate stay constant.

What is the difference between g = b × r and the sustainable growth rate?

In AFM they are used in the same way: growth that can be financed from retained earnings at a given return. Use g = b × r as the working formula unless the question defines something different.

How long should the explicit forecast period be?

Use the period the question gives. If you must choose, pick a period long enough for growth to settle to a rate the business can sustain, commonly three to five years. Justify your choice.

What growth rate should I use for the steady state?

Use a rate close to long-run growth in the economy or inflation, and always below the discount rate. A higher figure is hard to defend, because no firm can outgrow the economy for ever.