Question

Discuss the most common and current real-life uses of terminal values in cash flow analysis, and the pros and con's of this calculation process. (Words should be between 400 to 500 with at least 3 paragraphs.

Answer 1

The most common and current real-life uses of Terminal Values in Cash flow analysis are as follow:

First of all we must know about the Terminal value, It determines the value of the investment after a specific period of time by using a specific rate of interest.

Common Uses of the Terminal Values in Cash flow:

Terminal values determines the company values in perpetuity beyond a set forecast period commonly Five years.Companies can forecast future cash flows with easiness and which helps the company to decide on the future investments and expenditure and how much of the dividend should be declared in future as well. Discounted cash flow method is a most popular method to calculate terminal Values. The forecast period is usually about 5 years if it exceeds then the accuracy of projections suffers.

Pros and cons of the terminal values are as follows:

There are two methods by which it is calculated first is the "Perpetual method(Gordon Growth method) and second is the Exit multiple method.While using Perpetual method it is necessary to assume that business will continue to generate cash flows at a constant rate forever and Exit multiple method assumes that the business will sold at the end of the stipulated period or projection period.

Pros and cons of these methods calculations are as follows:

Perpetual method helps the company to decide rationally regarding the future expenditures and investments because this method assumes that the business will continue its operation forever while on the other hand it is difficult to know the precise time when the company may shut down its operations and the greatest disadvantage of the perpetuity Growth model is that it is not measured through the market driven analytics which is used in the Exit multiple method. In perpetual method the terminal growth rate is usually matched with the long term rate of inflation but not higher than the GDP(Gross domestic Product) growth rate.

And In Exit multiple method it is helpful to calculate the implied terminal growth rate and because of a multiple that may look fine at the first stage can actually entail a terminal growth rate that is unrealistic.This method has an advantage of market driven analytics and this analytics helps in knowing terminal values based on statistics present in a proven market regarding the similar transactions and this feature of Exit multiple method provides a certain level of confidence that the valuation accurately interpret how the market would value the company in reality.