Let say that it's 1 January 2023 and I am projecting out 5 years to run a DCF. When calculating my terminal value, I would run the following calculation: (FCF year 5 * (1+g)) / (r-g). I would then discount that to the present using an exponent of 5 years. Why is that? Why do we use 5 for the exponent and not 6?
Mathematically, the PV of a growing perpetuity is PV = FCF / (WACC - g) (http://www.netmba.com/finance/time-value/perpetui…). When we multiply FCF by (1+g), aren't we first calculating FCF at Year 6 and then the PV of the terminal value at Year 6?
Sorry if my question is confusing - essentially I am confused as to why we multiply FCF by (1+g) in Year 5.
Thank you.
The present value of the terminal value is discounted based on year 5 because, 1. Perpetuity is theoretical and is a calculation that occurs at the end of the projection period not after the projection period, 2. The end of the projection period represents an theoretical exit, and thus, the terminal value must be discounted based off the “exit” period. I’m sure I am missing something but essentially the growth to year 5 cash flows does not imply progression to a new period but rather provide a total value that reflects positive FCF growth.
But mathematically, the present value at year 5 of the terminal value is just FCF year 5 / (WACC - growth rate). Why do we multiply year 5 cash flows with (1+g)?
Because you want the value of Year 6 to start growing in perpetuity, rather than the value of Year 5 that you've already used and discounted previously?
So if terminal value is calculated based on FCF at Year 6, why don't we use 6 as the exponent when discounting to the present value?
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