Last time we learned to project future cash flows for a business. But now we face a crucial question: how do we convert those future cash flows into today's value?

The answer lies in choosing the right discount rate - the rate of return investors require for taking on this investment's risk.

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Why would a riskier business require a higher discount rate than a safer one?

The discount rate reflects the minimum return investors demand. If you can earn 8% risk-free in government bonds, you'd demand higher returns for riskier business investments.

A stable utility company might require 10% returns, while a tech startup might need 20% to justify the higher risk.

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Which would you demand a higher return from: investing in Coca-Cola or a new cryptocurrency company?

For most companies, we use WACC - Weighted Average Cost of Capital. This blends the cost of debt (interest rates) with the cost of equity (what shareholders require).

WACC reflects how the company finances itself through both debt and equity, weighted by their proportions in the capital structure.

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Why would debt typically cost less than equity for most companies?

Here's a simplified WACC example: if a company is 70% equity requiring 12% returns and 30% debt costing 6%, then:

WACC = (0.70 × 12%) + (0.30 × 6%) = 8.4% + 1.8% = 10.2%

This 10.2% becomes our discount rate for valuing the business.

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All else equal, how would increasing a company's debt share affect its WACC?

Now comes terminal value - often the trickiest part of DCF analysis. Most businesses don't disappear after our 5-10 year projection period; they continue operating indefinitely.

Terminal value captures all cash flows beyond our explicit forecast period. Surprisingly, it often represents 70-80% of total business value!

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Why might terminal value represent such a large portion of total business value?

The most common terminal value method assumes the business grows at a modest rate forever - called the perpetual growth approach.

We typically use GDP growth rates (2-3%) as our perpetual growth assumption, since no company can grow faster than the economy indefinitely.

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What would happen if we assumed 15% perpetual growth for terminal value?

The terminal value formula is: Final Year Cash Flow × (1 + Growth Rate) ÷ (Discount Rate - Growth Rate)

If Year 5 cash flow is $100M, growth is 3%, and WACC is 10%, then Terminal Value = $100M × 1.03 ÷ (10% - 3%) = $1.47B

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Which input—discount rate, growth rate, or final cash flow—has the biggest impact on terminal value?

Remember: small changes in discount rates or terminal growth rates dramatically impact DCF values. This sensitivity is both DCF's strength and weakness.

It forces you to think carefully about assumptions, but also means results can vary significantly with minor assumption changes.

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How might you test whether your DCF assumptions are reasonable?

Type

Multiple Choice

Practice Question

Company XYZ has a WACC of 12% and expects 3% perpetual growth. If final year cash flow is $50M, what's the terminal value?

A. $578M
B. $455M
C. $417M
D. $367M

Suggested Answers

• A - Correct
• B
• C
• D