Question

How do you calculate terminal growth rate and terminal weighted average cost of capital?

Answer 1

Terminal value growth rate

In most of the valuation models, terminal growth rate is taken to be a number between the inflation rate and the long term GDP growth rate. However, the estimate of GDP growth rate may differ. Many bankers tend to take US or other developed economies' growth rate as long term growth rate since it is a developed economy and it is generally believed that it is difficult for any economy to grow at a faster rate than the developed economies. However, some may prefer to take developing economy's growth rate as long term growth rate which is a little inappropriate.

Terminal WACC

Let us break the components of WACC:

1. Cost of equity = R_f + (R_m-R_f) *

Risk free rate and the equity risk premium shall remain the same that we have used to make explicit forecasts since we take 10-year or longer duration government bond yields and equity risk premium is taken on the basis of a long historical data. However, if we are evaluating a company in a emerging market currency, we may not take the country risk premium in the long run and preferably use the US or other developed economies' risk premium.

Beta, on the other hand, can be lowered to tend towards long term beta of the company. Long term beta is calculated by giving 2/3rd weight to the current beta and 1/3rd to long term beta of 1.0

2. Cost of debt

Cost of debt may be taken to be lower than the current cost since in the long run, we have stable cash flows and hence, risk of the debt may be lower.

3. Weights used

In the long run, we may also converge the debt to equity ratio towards the average industry ratio.

However, in most of the practical cases, we have used the same WACC througout rather than using a different WACC for the terminal value.