Question

Do small changes in the assumptions pertaining to the estimation of the terminal value have a significant impact on the calculation of the total value of the target firm? If so, why?

Answer 1

Answer-

Yes, the small changes in the assumptions for the estimation of terminal value will significantly impact the total value of target firm.

Terminal Value ( TV) = FCFFn x ( 1 +g) / (WACC -g)

FCFFn = Free cash flow of firm in nth or last year
WACC = Weighted average cost of capital
g = estimated growth rate in perpetuity

The assumptions in the growth rate in perpetuity and the FCFFn will have a high impact in the obtained terminal value.

Research shows that the terminal value can contribute approximately 75% of the value in a 5-year Discounted Cash Flow (DCF) method of evaluation  and 50% of the value in a 10-year DCF evaluation. The rest are the present values of estimated cash flows.

The 75 % of the value for a 5 year DCF model is staggering and can impact the final target value obtained on calculation.

Therefore the small changes in assumptions to calculate terminal value will significantly impact the target value due to its high contribution in DCF method which is a commonly used methodology in valuations.