Introductory Corporate Finance: Cash Flow Estimation - Terminal Cash, Flows Salvage Recovery of NWC

What This Is

Terminal cash flows, also known as salvage value, represent the residual value of a company's assets after all operations have ceased. This concept is crucial in corporate finance as it affects a company's valuation, particularly in the context of mergers and acquisitions, bankruptcy, and terminal value calculations. For instance, consider a company like Tesla, which has a significant terminal cash flow due to its brand value, patents, and manufacturing capabilities. If Tesla were to be sold, its terminal cash flow would be a significant component of its sale price.

Key Formulas & Models

• Terminal Value (TV) = CFt / (r - g) – terminal value represents the present value of future cash flows; CFt is the terminal cash flow, r is the discount rate, and g is the growth rate.
• CFt: terminal cash flow
• r: discount rate

• g: growth rate

• Salvage Value = NWC + PP&E – salvage value represents the residual value of a company's assets; NWC is net working capital, and PP&E is property, plant, and equipment.

• NWC: net working capital

• PP&E: property, plant, and equipment

• Recovery of NWC = (NWC / (1 + r))^(1/g) – recovery of NWC represents the present value of NWC at the terminal date; NWC is net working capital, r is the discount rate, and g is the growth rate.

• NWC: net working capital
• r: discount rate

• g: growth rate

• Terminal Cash Flow (CFt) = EBIT(1 - T) + Depreciation + Interest - Capital Expenditures – terminal cash flow represents the cash flow available to shareholders at the terminal date; EBIT is earnings before interest and taxes, T is the tax rate, Depreciation is depreciation expense, Interest is interest expense, and Capital Expenditures is capital expenditures.

• EBIT: earnings before interest and taxes
• T: tax rate
• Depreciation: depreciation expense
• Interest: interest expense

• Capital Expenditures: capital expenditures

• Discount Rate (r) = WACC – discount rate represents the cost of capital; WACC is the weighted average cost of capital.

• WACC: weighted average cost of capital

• Growth Rate (g) = ROE × (1 - Retention Ratio) – growth rate represents the rate at which a company's earnings grow; ROE is return on equity, and Retention Ratio is the ratio of retained earnings to net income.

• ROE: return on equity

• Retention Ratio: ratio of retained earnings to net income

• Sustainable Growth Rate = ROE × (1 - Retention Ratio) – sustainable growth rate represents the rate at which a company's earnings can grow without requiring external financing; ROE is return on equity, and Retention Ratio is the ratio of retained earnings to net income.

• ROE: return on equity
• Retention Ratio: ratio of retained earnings to net income

Step-by-Step Calculation

1. Calculate the terminal cash flow (CFt) using the formula: CFt = EBIT(1 - T) + Depreciation + Interest - Capital Expenditures.
2. Calculate the discount rate (r) using the formula: r = WACC.
3. Calculate the growth rate (g) using the formula: g = ROE × (1 - Retention Ratio).
4. Calculate the terminal value (TV) using the formula: TV = CFt / (r - g).
5. Calculate the salvage value using the formula: Salvage Value = NWC + PP&E.
6. Calculate the recovery of NWC using the formula: Recovery of NWC = (NWC / (1 + r))^(1/g).

Common Mistakes

• Mistake: Ignoring the recovery of NWC in terminal value calculations.
• Correction: Include the recovery of NWC in terminal value calculations to accurately reflect the present value of NWC at the terminal date.

• Counterexample: A company with a significant amount of NWC, such as a retailer, may have a substantial recovery of NWC that affects its terminal value.

• Mistake: Using the wrong discount rate (r) in terminal value calculations.

• Correction: Use the WACC as the discount rate (r) to accurately reflect the cost of capital.

• Counterexample: A company with a high WACC, such as a company with high debt, may have a higher discount rate (r) that affects its terminal value.

• Mistake: Ignoring the growth rate (g) in terminal value calculations.

• Correction: Include the growth rate (g) in terminal value calculations to accurately reflect the rate at which a company's earnings grow.
• Counterexample: A company with a high growth rate (g), such as a technology company, may have a higher terminal value due to its growth prospects.

Exam / CFA Tips

• Tip: Be careful when using the M&M Proposition I (no taxes) and M&M Proposition II (with taxes) in terminal value calculations.
• Why: The M&M Proposition I assumes that firm value is independent of capital structure, while the M&M Proposition II assumes that firm value increases with debt due to the interest tax shield.

• Tricky distinction: The M&M Proposition I is used when taxes are zero, while the M&M Proposition II is used when taxes are positive.

• Tip: Be careful when using the IRR vs NPV ranking in terminal value calculations.

• Why: The IRR ranking is used when the project has a positive NPV, while the NPV ranking is used when the project has a negative NPV.
• Tricky distinction: The IRR ranking is sensitive to the discount rate, while the NPV ranking is not.

Quick Practice Problem

A company has EBIT of $10M, interest $2M, tax 25%, depreciation $1M, and capital expenditures $5M. Compute the terminal cash flow (CFt).

Answer: CFt = $10M(1 - 0.25) + $1M + $2M - $5M = $6.25M + $1M + $2M - $5M = $4.25M

Explanation: The terminal cash flow (CFt) is calculated using the formula: CFt = EBIT(1 - T) + Depreciation + Interest - Capital Expenditures.

Last-Minute Cram Sheet

1. Terminal cash flow (CFt) = EBIT(1 - T) + Depreciation + Interest - Capital Expenditures.
2. Discount rate (r) = WACC.
3. Growth rate (g) = ROE × (1 - Retention Ratio).
4. Sustainable growth rate = ROE × (1 - Retention Ratio).
5. Terminal value (TV) = CFt / (r - g).
6. Salvage value = NWC + PP&E.
7. Recovery of NWC = (NWC / (1 + r))^(1/g).
8. In M&M Proposition I (no taxes), firm value is independent of capital structure.
9. In M&M Proposition II (with taxes), firm value increases with debt due to the interest tax shield.
10. The IRR ranking is sensitive to the discount rate, while the NPV ranking is not.