2.2.5 Discounted Cash Flow: Part 2

Welcome to On Judgement. A junior analyst adds a £204m terminal value directly to today’s value. The terminal figure belongs at year 3. What is missing? Take a first view. You can change it when you have considered the evidence.

The simplified unlevered bridge is EBIT × (1−operating tax rate) + depreciation/amortisation − capex − increase in operating working capital. Do not deduct interest in this bridge when financing is reflected through WACC. The increase in working capital is a use of funds. Check tax, leases and other adjustments in real cases; this teaching model excludes those complications explicitly.

A simplified cost of equity can use a risk-free proxy plus beta times an equity risk premium. Beta describes sensitivity to market returns, not every dimension of risk. Blend equity cost and after-tax debt cost using compatible market-value financing weights. The result is an assumption, not a permanent property of a company. The cash-flow currency and nominal/real basis must match the rate.

For the teaching perpetuity, terminal value at year N = FCF in year N × (1+g)/(r−g), requiring r>g. It is an endpoint value, then discounted to today. Long-run growth needs sustaining investment and plausible economics; it is not free growth from nothing. A large terminal contribution means the model depends heavily on distant assumptions and deserves explicit scrutiny.

Sum explicit-year present values and discounted terminal value for the enterprise operating estimate. Subtract defined debt and other relevant claims, and add excess cash or other separately valued assets consistently. Divide by the appropriate shares. Avoid subtracting debt twice or adding operating cash already captured in value. Round outputs sensibly, keep full precision in workings, and inspect the share count.

Let's work through Harbour’s original three-year DCF · £m. Assume end-year FCFF 12, 14 and 16 for years 1–3; WACC 10%; terminal growth 2%; debt 50; excess cash 30; 20m shares. No other claims/assets. These are hypothetical forecasts, not reported cash or a market recommendation. Pause here and try the calculation or reasoning before continuing.

PV explicit cash = 12/1.10 + 14/1.10² + 16/1.10³ = £34.500m. Year-3 terminal value = 16 × 1.02/(.10−.02) = £204m. PV terminal = 204/1.10³ = £153.268m. EV = 34.500 + 153.268 = £187.769m. Equity = 187.769 − 50 + 30 = £167.769m. Per share = 167.769/20 = £8.388, about £8.39.

About 81.6% of EV is the terminal present value. The model depends strongly on long-run assumptions; the £8 observed price is close to this base estimate, not automatically a large margin of safety.

Now try the choices in this lesson. If your answer changes, identify the reason. Bridge enterprise value to a share estimate. Use the case activities to put the idea into your own words, and return to the evidence when more than one conclusion is defensible.