For an investment with a defined time horizon, such as a new-product launch, managers project annual cash flows for the life of the project, discounted at the cost of capital. However, capital investments without defined time horizons, such as corporate acquisitions, may generate returns indefinitely.

When cash flows cannot be projected in perpetuity, managers typically estimate a terminal value: the value of all cash flows beyond the period for which predictions are feasible. A terminal value can be quantified in several ways; the most common (used by 46% of respondents to the Association for Financial Professionals survey) is with a perpetuity formula. Here’s how it works:

First, estimate the cash flow that you can reasonably expect—stripping out extraordinary items such as one-off purchases or sales of fixed assets—in the final year for which forecasts are possible. Assume a growth rate for those cash flows in subsequent years. Then simply divide the final-year cash flow by the weighted-average cost of capital minus the assumed growth rate, as follows:

 $\Large \text{TERMINAL VALUE} = \frac{\text{NORMALIZED FINAL YEAR CASH FLOW}}{\text{WACC}+\text{GROWTH RATE}}$

It’s critical to use a growth rate that you can expect will increase forever—typically 1% to 4%, roughly the long-term growth rate of the overall economy. A higher rate would be likely to cause the terminal value to overwhelm the valuation for the whole project. For example, over 50 years a $10 million cash flow growing at 10% becomes a $1 billion annual cash flow. In some cases, particularly industries in sustained secular decline, a zero or negative rate may be appropriate.

HBR.ORG: To see how terminal-value growth assumptions affect a project’s overall value, try inputting different rates in the online tool at hbr.org/cost-of-capital.
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Sat, 07 Jul 2012 17:06:00 GMT
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dirkjan
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Sat, 07 Jul 2012 17:06:00 GMT
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Do You Know Your Cost of Capital? - Harvard Business Review
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dirkjan