Corporate and Project Finance Modeling

Chapter 29Normalizing Terminal Year Cash Flows for Stable Working Capital Investment

The next few chapters consider various adjustments to normalized cash flow in the terminal period that should be made to accurately measure value when growth rates change from short-term assumptions to long-term steady rates and when rates of return on investment are assumed to stabilize. If you review articles about valuation, you can comb the Internet and find hundreds of references to normalizing cash flow in the terminal period. But it is difficult to find anybody who explains exactly how you should compute this normalized cash flow in practice. Instead, you typically just come accross some general language about cash flow being at a steady level. This chapter introduces the notion of using stable relationships to determine normalized cash flow. The effects of stable relationships that can be used to derive normalized cash flow and that result from changing growth and rate of return come into play in addressing various issues. The stable ratios are used in normalizing cash flow in the terminal period, computing terminal value using the value driver formula (1 – g/ROIC)/(WACC – g), and deriving implied price/earnings (P/E) and enterprise value/earnings before interest, taxes, depreciation, and amortization (EV/EBITDA) ratios.

To understand both the valuation theory and the modeling mechanics involving changes that move from a growth rate in the explicit period to a stable growth rate, it ...