DCF Stub Period - Entry and Exit Annual Financial Model

Based on the most helpful WSO content, here's how you can handle a stub period entry and exit date in an annual DCF model:

Key Adjustments for Stub Period Entry and Exit Date

1. Free Cash Flow at Exit:

   • Stub Period Adjustment: Since your entry date is 30-Sep-24 and your exit date is 30-Sep-29, you need to adjust the free cash flow for the stub period. This involves prorating the free cash flow for the stub period.
   • Calculation: If your financial year ends on 31-Dec, you will need to calculate the free cash flow for the period from 30-Sep-24 to 31-Dec-24 and then for each full year thereafter until 30-Sep-29. For the stub period at the end, you will prorate the free cash flow from 1-Jan-29 to 30-Sep-29.

2. Terminal Value Calculation (Perpetuity Growth Method):

   • Terminal Free Cash Flow: The terminal free cash flow should be calculated for the year following the exit date. Since your exit date is 30-Sep-29, you will use the free cash flow for the period from 1-Oct-28 to 30-Sep-29 and then grow it by the perpetuity growth rate.
   • Formula: [ \text{Terminal Value} = \frac{\text{FCF}{\text{Exit}} \times (1 + g)}{\text{WACC} - g} ] where ( \text{FCF}{\text{Exit}} ) is the free cash flow for the period from 1-Oct-28 to 30-Sep-29, ( g ) is the perpetuity growth rate, and ( \text{WACC} ) is the weighted average cost of capital.

3. Discount Period / Discount Factor:

   • Discounting Stub Periods: You need to discount the free cash flows and terminal value back to the valuation date (30-Sep-24). For the stub periods, you will use a fraction of the year.
   • Discount Factor Calculation: [ \text{Discount Factor} = \frac{1}{(1 + \text{WACC})^{t}} ] where ( t ) is the time in years from the valuation date to the cash flow date. For example, the discount factor for the stub period from 30-Sep-24 to 31-Dec-24 would be calculated using ( t = \frac{3}{12} ) (i.e., 3 months).

Simplified Example

• Valuation Date: 30-Sep-24
• Last Financial Year End: 31-Dec-23
• Hold Period: 5 years (exit on 30-Sep-29)
• Discounting: Full Year

Steps:

1. Calculate Free Cash Flow for Stub Periods:

   • From 30-Sep-24 to 31-Dec-24: Prorate the annual FCF.
   • From 1-Jan-29 to 30-Sep-29: Prorate the annual FCF.

2. Calculate Terminal Value:

   • Use the FCF from 1-Oct-28 to 30-Sep-29.
   • Apply the perpetuity growth method formula.

3. Discount Free Cash Flows and Terminal Value:

   • Discount each FCF back to 30-Sep-24 using the appropriate discount factor for each period.
   • Discount the terminal value back to 30-Sep-24.

By following these steps, you can accurately incorporate a stub period entry and exit date into your annual DCF model.

Sources: DCF Modeling Course ~ Pre-training text.pdf, Why do I subtract the g from the Wacc in the terminal value calculation?, Notes for Technical Interview Questions