In a discounted cash flow valuation, what is the terminal value and why is it included?

• A. Terminal value captures the value of cash flows beyond the forecast horizon; it is added to the present value.
• B. Terminal value is the final cash inflow in year 1.
• C. Terminal value is the initial investment returned at t=0.
• D. Terminal value is the tax shield on depreciation.

Answer: (C)

In a discounted cash flow valuation, you must capture not only the cash flows you can forecast explicitly but also the value of all cash flows that occur after that forecast period. The thing that represents that continuing value is the terminal value. It reflects the value of expected cash flows beyond the explicit forecast horizon, typically estimated either by a perpetuity growth model or by applying an exit multiple. Terminal value is included because a business is expected to generate cash flows far into the future, and ignoring those beyond the forecast window would underestimate the total value. The terminal value is then brought back to present value and added to the present value of the explicit forecast cash flows to obtain the total valuation. It is not the initial investment at time zero, nor the final cash inflow in year one, nor a tax shield on depreciation.