What is the terminal value formula based on?

The terminal value formula represents the present value of all future cash flows of a business beyond the forecast period, extending indefinitely. The correct formula incorporates the final year’s free cash flow, adjusted for growth, divided by the difference between the weighted average cost of capital (WACC) and the growth rate (g).

This approach is grounded in the concept of perpetuity, which assumes that after a certain forecast period, cash flows will continue to grow at a steady rate indefinitely. By taking the final year of free cash flow and multiplying it by (1 + g), you reflect the anticipated growth for the next period. The denominator (WACC - g) accounts for the required rate of return adjusted for growth, which helps determine how much future cash flows are worth in today's terms.

Using free cash flow rather than EBIT or total assets is essential, as free cash flow provides a more accurate picture of the cash available to all capital providers, rather than focusing narrowly on earnings or asset values. This makes the methodology robust for valuation purposes, especially in leveraged finance scenarios where understanding the cash flow generation capability of a firm is critical.

The other choices fail to align with the standard valuation practices employed in finance for calculating terminal value. For instance, using EBIT does