FREE online courses on Mergers & Acquisitions - Chapter 5 - Terminal Values

 

It is quite possible that free cash flows will be generated well beyond our forecast period. Therefore, many valuations will add a terminal value to the valuation forecast. The terminal value represents the total present value that we will receive after the forecast period.

 

Example 12 - Adding Terminal Value to Valuation Forecast

 

Net Present Value for forecast period (Example 9)           $ 423,500

Terminal Value for beyond forecast period                         183,600

                   Total NPV of Target Company                  $ 607,100

 

There are several approaches to calculating the terminal value:

 

Dividend Growth: Simply take the free cash flow in the final year of the forecast, add a nominal growth rate to this flow and discount the free cash flow as a perpetuity. Terminal value is calculated as:

 

       Terminal Value = FCF ( t + 1 ) / wacc - g

       ( t + 1 ) refers to the first year beyond the forecast period

       wacc: weighted average cost of capital

       g: growth rate, usually a very nominal rate similar to the overall economy          

It should be noted that FCF used for calculating terminal values is a normalized free cash flow (FCF) representative of the forecast period.

 

Example 13 - Calculate Terminal Value Using Dividend Growth

 

You have prepared a forecast for ten years and the normalized free cash flow is $ 45,000. The growth rate expected after the forecast period is 3%. The wacc for the Target Company is 12%.

 

($ 45,000 x 1.03) / (.12 - .03) = $ 46,350 / .09 = $ 515,000

 

If we wanted to exclude the growth rate in Example 13, we would calculate terminal value as $ 46,350 / .12 = $ 386,250. This gives us a much more conservative estimate.

 

Adjusted Growth: Growth is included to the extent that we can generate returns higher than our cost of capital. As a company grows, you must reinvest back into the business and thus free cash flows will fall. Therefore, the Adjusted Growth approach is one of the more appropriate models for calculating terminal values.

 

Terminal Value = EBIT ( 1 - tr) ( 1 - g / r ) / wacc - g

tr: tax rate    g: growth rate                   r: rate of return on new investments

 

Example 14 - Calculate Terminal Value Using Adjusted Growth

 

Normalized EBIT is $ 60,000 and the expected normal tax rate is 30%. The overall long-term growth rate is 3% and the weighted average cost of capital is 12%. We expect to obtain a rate of return on new investments of 15%.

 

$ 61,800 ( 1 - .30 ) ( 1 - .03 / .15 ) / (.12 - .03) =

$ 43,260 ( .80 ) / .09 = $ 384,533

 

If we use Free Cash Flows, we would have the following type of calculation:

 

Earnings Before Interest Taxes (EBIT)       $ 60,000

Remove taxes (1 - tr )                               x    .70

Operating Income After Taxes                     42,000

Depreciation (non cash item)                      12,000

Less Capital Expenditures                          (  9,000)

Less Changes to Working Capital                  ( 1,000)

Free Cash Flow                                        44,000

Growth Rate @ 3%                                   x   1.03

Free Cash Flow ( t + 1 )                            45,320

Adjust Growth > Return on Capital               x    .80

Adjusted FCF ( t  + 1 )                              36,256

Divided by wacc - g or .12 - .03                     .09

Terminal Value                                      $ 402,844     

 

EVA Approach: If your valuation is based on economic value added (EVA), then you should extend this concept to your terminal value calculation:

 

Terminal Value = NOPAT ( t + 1 ) x ( 1 - g / rc ) / wacc - g

NOPAT: Net Operating Profits After Taxes  rc: return on invested capital

 

Terminal values should be calculated using the same basic model you used within the forecast period. You should not use P / E multiples to calculate terminal values since the price paid for a target company is not derived from earnings, but from free cash flows or EVA. Finally, terminal values are appropriate when two conditions exist:

 

1. The Target Company has consistent profitability and turnover of capital for generating a constant return on capital.
2. The Target Company is able to reinvest a constant level of cash flow because of consistency in growth.

 

If these two criteria do not exist, you may need to consider a more conservative approach to calculating terminal value or simply exclude the terminal value altogether.

 

Example 15 - Summarize Valuation Calculation Based on Expected Values under Three Scenarios

 

Present Value of FCF's for 10 year forecast period $ 62,500

Terminal Value based on Perpetuity                                 87,200

Present Value of Non Operating Assets                              8,600

Total Value of Target Company                                   158,300

Less Outstanding Debt at Fair Market Value:

Short-Term Notes Payable                                (   6,850)

Long-Term Bonds (25 year Grade BB)                            ( 26,450)

Long-Term Bonds (10 year Grade AAA)                ( 31,900)

Long-Term Bonds ( 5 year Grade BBB)                           ( 22,700)

Present Value of Lease Obligations                     ( 17,880)

Total Value Assigned to Equity                                       52,520

Outstanding Shares of Stock                                            7,000

Value per Share ($ 52,520 / 7,000)                     $     7.50

 

 

Example 16 - Calculate Value per Share

 

You have completed the following forecast of free cash flows for an eight year period, capturing the normal business cycle of Arbor Company:

 

Year                  FCF

2001             $ 1,550

2002                1,573

1,598

1,626

1,656

1,680

1,703

1,725

 

Arbor has non-operating assets of $ 150. These assets have an estimated present value of $ 500. Based on the present value of future payments, the present value of debt is $ 2,800. Terminal value is calculated using the dividend growth model. A nominal growth rate of 2% will be used. Arbor's targeted cost of capital is 14%. Arbor has 3,000 shares of stock outstanding. What is Arbor's Value per Share?

 

Year         FCF               x     P.V. @ 14% Present Value

2001   $ 1,550                   .8772            $ 1,360

2002      1,573                  .7695               1,210

1,598  .6750               1,079

1,626  .5921                  963

1,656  .5194                  860

1,680  .4556                  765

1,703  .3996                  681

1,725  .3506                  605

Total Present Value for Forecast Period                        $  7,523       

Terminal Value = ($ 1,725 x 1.02) / (.14 - .02) =              14,663

Value of Non Operating Assets                                           500

Total Value of Arbor                                           22,686

Less Value of Debt                                          (  2,800)

Value of Equity                                                         19,886

Shares Outstanding                                            3,000

Value per Share                                              $   6.63