In a DCF valuation, what are the key steps to estimate the terminal value, and how do you choose the perpetuity growth rate?

• A. Terminal value is calculated as FCF in the final forecast year × (1 + g) / (WACC − g); choose g near long-term GDP or industry growth; ensure g < WACC; perform sensitivity checks.
• B. Terminal value is based on final year's net income multiplied by a fixed multiple; growth rate irrelevant.
• C. Terminal value is equal to current cash balance; g can be any number.
• D. Terminal value uses equity value divided by WACC.

Answer: (B)

The idea being tested is how to value cash flows beyond the explicit forecast horizon and how to choose the growth assumption that drives that value. In a DCF, the terminal value captures all future cash flows after the explicit forecast period. The standard way to estimate it is the Gordon growth approach: take the free cash flow to the firm in the final forecast year, grow it at a constant rate g into perpetuity, and divide by the difference between the discount rate (WACC) and g. So TV = FCF_final × (1 + g) / (WACC − g). This amount is then discounted back to present value at WACC along with the explicit forecast cash flows.

Choosing g involves grounding it in realistic long-run growth. Typically you align g with long-term GDP growth or the industry’s sustainable growth rate, and you must keep g below WACC to avoid infinite value. It’s important to test how sensitive the terminal value is to changes in g and WACC, using a small set of plausible scenarios. If you use an alternative measure like FCFE or an exit multiple approach, the specifics shift, but the core idea remains: the terminal value should reflect perpetual, sustainable growth and be evaluated against reasonable macro and industry assumptions.