In a two-stage DCF valuation model, how is the Terminal Value (TV) computed using the perpetual growth method, and what economic ceiling should constrain the perpetual growth rate (g)?

[ A ]TV = [Final Year FCFF * (1 + g)] / (WACC - g); the perpetual growth rate (g) must be capped at or below the long-term nominal GDP growth rate of the economy in which the firm operates.[ CORRECT ]

[ B ]TV = Current Market Cap * 100; the perpetual growth rate must be assumed at 50% per annum forever.

[ C ]TV = Total statutory audit fees paid over the previous 50 years with zero discounting applied.

[ D ]Terminal Value is always assumed to be exactly zero because all businesses cease operations after 5 years.

Takeaway

Option A is correct: TV = [Final Year FCFF * (1 + g)] / (WACC - g); the perpetual growth rate (g) must be capped at or below the long-term nominal GDP growth rate of the economy in which the firm operates.

Derivation

In a DCF model, Terminal Value captures the value of all cash flows beyond the explicit forecast period. Using the perpetual Gordon Growth approach: Terminal Value = FCFF_(n+1) / (WACC - g) = [FCFF_n * (1 + g)] / (WACC - g). Economically, no individual commercial company can grow faster than the overall economy indefinitely; therefore, the perpetual terminal growth rate (g) is strictly capped at the sustainable long-term nominal GDP growth rate (typically 4-6%). The computed TV is then discounted back to present value. This tests terminal value modeling. A common error is assuming unsustainable 15-20% terminal growth.

Why the others fail

B — TV = Current Market Cap * 100; the perpetual growth rate must be assumed at 50% per annum forever.

Assuming a perpetual 50% growth rate is an economic impossibility that mathematically causes DCF models to explode to infinity.

C — TV = Total statutory audit fees paid over the previous 50 years with zero discounting applied.

Audit fees are minor administrative expenses and have zero mathematical relevance to terminal business cash flows.

D — Terminal Value is always assumed to be exactly zero because all businesses cease operations after 5 years.

Healthy businesses are going concerns with indefinite operational life; assuming zero terminal value severely undervalues companies.