Corporate and Project Finance Modeling

Chapter 32Terminal Value and the Ability of a Company to Earn Returns above the Cost of Capital

The most fundamental objective of any business entity is to create economic profit. Economic profit occurs when the rate of return earned exceeds the opportunity cost of capital that reflects the risk of the business. If a company earns economic profit, new investment and capital expenditures increase the value of the corporation. If the return is below the cost of capital, management should contract the business. Any financial model that computes the value of a firm implicitly measures the ability of a firm to earn an economic profit. For business enterprises operating in a competitive environment, earning an economic profit is certainly not easy, and companies are by no means always able to earn a return above their cost of capital. But if a business cannot earn a return on invested capital that exceeds the weighted average cost of capital (WACC), it should try to exit the business or it may be forced to exit in one way or another. In computing valuation multiples, the next three chapters address different ways to account explicitly for the level of economic profit in the terminal value section of a corporate financial model.

The discussions of stable ratios in Chapters 29, 30, and 31 that address normalized cash flow do not explicitly discuss the return on invested capital. But that does not mean return on invested capital is not an implicit assumption in the valuation analysis ...