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

When using free cash flow valuation with a perpetuity growth terminal value, which limitation is most significant?

The main limitation is that terminal value usually makes up most of the valuation and is very sensitive to the growth rate and WACC assumptions, since value depends on the gap between them. Small estimate changes therefore cause large swings in value.

  1. AThe terminal value often forms a large share of total value and is highly sensitive to the growth rate and WACC assumptionsCorrect
  2. BFree cash flows cannot be calculated for companies paying dividends
  3. CThe method ignores the tax shield on debt entirely in all circumstances
  4. DThe method can only be used for companies with no debt

Explanation

With a perpetuity formula, value depends on 1/(WACC - g), so small changes in g or WACC move value sharply, and terminal value is typically most of the total. The other statements are false: dividends do not prevent FCF calculation, WACC includes the tax shield, and debt-financed firms can be valued.

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