ACCA Strategic Professional · Advanced Financial Management · Valuation and the use of free cash flows
When valuing a company with DCF, which treatment of the terminal value is most appropriate?
Terminal growth should not exceed long-run economic growth in the relevant currency. A rate above WACC makes the perpetuity formula invalid, ignoring terminal value understates most companies, and the risk-free rate would not reflect business risk.
- AUse a perpetual growth rate no higher than long-run economic growth in the currency of the cash flowsCorrect
- BUse a perpetual growth rate above WACC to reflect strong competitive advantage
- CIgnore terminal value as it is speculative
- DDiscount the terminal value at the risk-free rate
Explanation
A perpetuity growth rate must be below the discount rate and should not exceed long-run nominal economic growth, otherwise the company would eventually exceed the economy. Growth above WACC makes the formula meaningless.
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