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Your effectively creating a perpetuity for the CF's. As time progresses and your 'n' increases, the cash flows are eventually discounted so much that they reach 0. This is done with the understanding that the company may not be around forever and extremely distant cash flows are both hard to project and potentially unlikely to be received.
I agree with that you do this because you are discounting a perpetuity but I would disagree with the characterization of it being done because the company may not be around forever. The whole point is that the company IS around for perpetuity, its just the discounted values of the future cash flows approaches zero with enough time.
In other words, the heavily discounted value is not because of uncertainty of the future cash flow existing, but because the opportunity cost is extremely high when you go far enough into the future.
Yea I would agree with you on that. I think the biggest take away is that cash flows 50 years from now are worth pretty much 0 from a valuation standpoint.
In a DCF you discount yearly cash flows to present value. Because forecasting beyond 5 or so years becomes a shot in the dark, you choose a terminal year (e.g., 5th year) and say the cash flows will grow at g% every year. You can use that growth rate to keep forecasting the cash flows and discounting every year as the number years go into infinity. Or you use the terminal calculation at the 5th year (i.e., terminal year) where you subtract out g in the denominator to get the SAME answer.
It is just a mathematical rearrangement of projecting cash flows into perpetuity using a constant growth rate and constant discount rate.
If you really wanted to, you could test this out by projecting the cash flows a really long time (e.g., 100 years). After the terminal year, just use a constant FCF growth rate and constant discount rate. This should be approximately equal to the 5 year DCF with the terminal calculation.
Agree with the question. Why would you subtract the growth of the economy from the WACC?
Not sure you should be looking at the formula like that. The valuation formulas are in effect the shortened formed of a summation process. The g is there by virtue of mathematical rearrangement, you should be looking at the equation in its entirety to make sense of it.
The terminal value (TV) is given as:
TV = CF(1+g)/(1+r) + CF(1+g)^2/(1+r)^2 + ....
Divide both sides by (1+g) and multiply by (1+r):
TV(1+r)/(1+g) = CF + CF(1+g)/(1+r) + CF(1+g)^2/(1+r)^2 + ....
Subtract the first equation from the second:
TV((1+r)/(1+g)-1) = CF => TV((1+r-1-g)/(1+g)) = CF
=> TV = CF(1+g)/(r-g)
thanks, helpful
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