Page 98 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Unit 4: Responsibility Centers

Approach 2: Terminal value is a stable perpetuity Notes

Terminal value =

Approach 3: Terminal value as a Multiple of Book value. The terminal value can be
estimated by multiplying the forecasted book value of capital by an approximate
market - to book ratio. Normally, the current market/book value ratio is taken as proxy
for future.
Approach 4: Terminal value as a Multiple of earnings – the terminal value under this
method is established by multiplying the forecasted terminal year profits by an
approximate price minus the earning multiple. As usual, the current price/earnings
multiple can be used as proxy for future.
5. What is the total asset employed as on date?
Illustration: The cash flows of a division of a company are given below:
(` Crores)

Year 1 Year 2 Year 3 Year 4 Year 5
Net operating profit after tax (1) 65 70.20 75.40 80.6 87.10
Depreciation expenses (2) 20 22 24 26 28
Capital expenditure (3) 30 32 35 37 40
Working capital (4) 20 22 23 25 27
Free cash flow (5) = (1) + (2) – (3) – (4) 35 38.20 41.40 44.60 48.10

Cash flows are expected to grow at 5% after 5th year.
Cost of capital is 15% and assets employed ` 325 crores.
Evaluate the performance of Division A.
Solution:

Year 1 Year 2 Year 3 Year 4 Year 5
Free cash flow terminal value 35 38.20 41.40 44.60 48.10
*505.05
Discount factor @ 15% 0.870 0.756 0.658 0.572 0.497
Discounted cash flow 30.45 28.88 27.24 25.51 274.91

Total of Discounted Cash Inflow 386.99
Less: Capital employed 325.00
NPV 61.99
IRR of the Division (approx) 20%

(i.e., the discount factor or the cost of interest the unit can bear)

Note: *Terminal value = ` 505.05 crores

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