Example: You are tasked with valuing Royal Company, a potential acquisition for
Sahitya Printing Press Limited. The acquisition is expected to bring backward integration
benefits. For this valuation, consider a forecast period of three years with free cash flows
(FCFs) provided, and calculate the terminal value using two methods: based on cash
flows and based on the P/E ratio.
Assumptions:
Royal has 2.5 million outstanding equity shares.
The equity beta is 1.28 , and the current P/ E ratio is 8 .
Sahitya's P/E ratio is 12 , and it has a WACC of 14 % .
Royal's debt ratio is assumed to be 30 % of the firm's value.
Risk-free rate is 8.5 % , and the market risk premium is 9 % .
Corporate tax rate is 35 % .
Use the following free cash flow projections for Royal for the next 3 years:
Capex Change in After calculation
PBDIT Depreciation ₹ NWC ₹ FCF ₹
Year
₹M ₹M
M M M
2024 120 40 20 15 57
2025 150 45 25 18 70.25
2026 180 50 30 20 84.5
The terminal value is estimated using the cash flow method and the P/E method at the
end of 2026.
Steps to Solve:
Step 1: Calculate the Cost of Equity and WACC for Royal
Cost of equity (using CAPM):
Cost of equity =0.085+0.09 ×1.83=0.25 or 25 %
WACC:
WACC =0.25 ×0.70+ 0.085×(1−0.35)× 0.30=0.19 or 19 %
Step 2: Estimate the Free Cash Flows (FCFs)
For the three years provided:
¿ FCF ( Year 1)=₹ 57 million
¿ FCF ( Year 2)=₹ 70.25 million
¿ FCF ( Year 3)=₹ 8 4.5 million
Step 3: Terminal Value Calculation
Method 1: Terminal Value Using Free Cash Flow Approach
Assuming FCF grows at a constant rate post-2026:
κ
FCF in 202 8 4.5
T V 2026 = ↓= =₹ 4 44 . 74 million
WACC 0.19
Method 2: Terminal Value Using P/E Approach
Using the P/E ratio of 8 and profit after tax (PAT) in 2026 (PAT assumed to be
50 % of PBDIT):
PA T 2026 =50 % ×180=₹ 90 million
T V 2026 =PA T 2026 × P/ E ratio =90× 8=₹ 720 million
Step 4: Present Value of FCFs and Terminal Value
Using a WACC of 19%, discount the FCFs and terminal value:
FCF (₹ PV Factor PV of FCF (₹
Year
Million) (19%) Million)
2024 57 0.8403 47.90
2025 70.25 0.7062 49.63
2026 84.5 0.5934 50.16
2026 (TV using
444.74 0.5934 263.96
FCF)
Total PV ₹ 411.65 million
Step 5: Equity Value and Value per Share
Total value of the firm (using FCF-based terminal value) = ₹ 379.21 million.
Equity value ¿ Total value ׿ debt ratio ¿=₹ 379.21×(1−0.30)=₹ 265.45
million.
Value per share ¿ Equity value ÷ 2.5 million shares ¿ ₹ 265.45 ÷ 2.5=₹ 106.18 per
share
Thus, the value of Royal is ₹ 106.18 per share ↓ wed on the FCF approach.
