Module II· DCF — Terminal ValueIntermediate
Question
Why must the terminal year FCF be normalized, and how do you do it?
Answer
Mechanics
in the terminal year you assume a steady state. Four normalization steps:
```
Capex = D&A × (1 + g) — no more growth capex
ΔNWC = NWC × g — only inflation-driven NWC increase
Taxes = Long-Run Tax Rate — no NOL effect
```
- Margins: for cyclical targets the forecast-end margin deviates from the long-run average — use the mid-cycle margin.
Deep diveShow more details
Example
a software company has a Year 5 EBITDA margin of 18% (growth phase), but 22% long-term after scaling. Year 5 is therefore not terminal-representative — carry the margin path into Year 6+ or extend the forecast period to 7+ years.
Common mistake
plugging the Year 5 FCF straight into Gordon, which overstates the terminal value.