Proper Determination of the Growth Rate for Growing Perpetuities: The Growth Rate for the Terminal Value

Abstract

In this paper we find restrictions for the value of a parameter used in defining the cost of capital for perpetuities and terminal values: the growth rate for the free cash flow. When defining the growth rate for the free cash flow the usual warning is to set it below the growth of the economy or the industry because in the long run the firm would be larger than the economy or the industry. This approach might be considered somewhat standard in the sense that usually they either take the growth of NOPLAT (mathematically) and/or check that it complies with the previous statement. However, in this paper we propose to find another objective limits deriving them from the formulation for the cost of capital in perpetuity and the traditional formula for the terminal value in a world where the discount rate for the tax savings is Kd, the cost of debt. These limits give additional criteria for determining the value of g. The limits are calculated in terms of real rate of growth. We use an example to show the effects of violating these limits. Calculating these limits is very important in valuation because usually the terminal value is a substantial portion of the levered value of the firm.