Annuity method - terminal value

Rappaport recommended using a method, analogous to an annuity, to calculate the terminal (or residual value). For consistency in this chapter, I have called it the terminal value.

How to calculate an annuity's value

If you draw a $30,000 pension (terminal year cash flow), what is the value of the principal (terminal year value) to produce that annual cash flow. We make the calculation using the risk free bond yield, here the 20 year Treasury bond, April 2003, at 4.8%.

                                  $30,000/.048 = $625,000

Use the industry' average cost of capital as the divisor

Based on Rappaport's research, during a sustainable product's mature phase, with many competing firms in the market, he concludes that returns are close to an industry's WACC, the industry's cost of capital.

This is a conservative logic, assuming competition drives down returns when a product is mature and the industry is stable. It is also a simple calculation; the industry WACCs are have been calculated by Ibbotson, from Prof. Damadron's data, or sources like an industry association.

For those who found this page through Google or Bing, this chapter is about setting your targeted yield (hurdle rate). Its sixteen short pages explains the subtlites and issues so consider starting at the beginning in a short story about a "boss" just invited into the C-level big leagues where she is asked to recommend the targeted yield. Might help your career.

"The boss" thought that this could be messy. We have got to be consistent and use just one cost of capital in the calculations: our firm's or the industry's. She felt that the logic must be clear and persuasive about how our firm plans to manage its capital when managers make the cost / benefit estimates in their action plans. But she knows it is human nature, giving choices on this fundamental number, to game the calculations to present the best outcome. Uhggggggg :o(