Normalizing Terminal Year Cash Flows for Stable Working Capital Investment

• Published in: Corporate and Project Finance Modeling pp. 369 - 376
• Format: Book Chapter
• Language: English
• Published: Hoboken, New Jersey John Wiley & Sons, Inc 29.10.2014
• Subjects: free cash flow components; normalized working capital change formula; normalized working capital investment; theoretical long‐term value
• ISBN: 9781118854365; 1118854365
• DOI: 10.1002/9781118957394.ch29

This chapter begins the discussion of computing stable ratios and normalized cash flow after growth rates change. Working capital movement is addressed before depreciation, capital expenditures, or deferred tax because the effect of working capital change occurs in one period while a change in capital expenditure affects future depreciation over the entire book life of the plant. When the terminal growth rate is lower than the growth rate in the explicit period, the working capital investment that is a component of indefinite free cash flow should also change. The normalized working capital change can be computed using the notion that the level of working capital to EBITDA remains constant if there is a change in growth. Using the constant WC/EBITDA ratio, the formula for normalized working capital changes is: WC change =WC/EBITDA×EBITDA (terminal year) × terminal growth rate/(1 + terminal growth rate). The validity of applying this formula when computing can be demonstrated with a three‐part model that includes a long‐term theoretical valuation. This exercise involves establishing the theoretical value without any terminal value calculation and then comparing this value to the value computed with and without a normalization adjustment. The final part of the chapter discusses how to include normalization adjustments in the valuation section of a financial model. To make the model transparent, separate lines should be included for all of the items that are subject to normalization.