In this workout, we are going to calculate a terminal value for Windermere Inc using the value driver formula. We're also asked to identify why this differs to the terminal value calculated using the Gordon Growth formula. Let's start by calculating terminal value using the value driver formula, we are given a discount rate of 10%, long-term growth of 4%, and long-term return on invested capital of 13.2% to use in our calculations, along with NOPAT and free cashflow forecasts for the next three years. And our terminal year is year three. Now, to calculate terminal value using the value driver formula, we're gonna start with the final year's NOPAT forecast of 13.3. Multiply that by one minus our growth rate divided by return on invested capital.

Multiply that by one plus the growth rate and divide all of that by our cost of capital, less the growth rate, and that gives us terminal value of 160.7.

Now let's calculate the terminal value using the Gordon Growth formula. This time we start with the final year's free cashflow forecast of 13. We multiply that by one plus long-term growth and divide that by our cost of capital, less our growth. And this time we get a terminal value of 225.3. Wow, that's quite a difference. So which figure is more sensible? Well, let's look at what is implied by the final year's free cash flow forecast. If we take our final year's NOPAT and our final year free cash flow that gives net reinvestment in the business of 0.3, now is a percentage of NOPAT that's 2.3% of NOPAT reinvested in the business. Now we know that the terminal growth rate of this company is 4%. Now we know that the percentage of NOPAT reinvested is equal to growth divided by return on invested capital. So we can reverse engineer this relationship to calculate the implied return on invested capital. So if we divide our long term growth rate of 4% by the level of reinvestment of 2.3%, This implies a return on invested capital in the terminal year of 177.3%. So this tells us that for a company to reinvest just 2.3% of their profits and achieve 4% growth in their capital base and earnings, they would need to be generating a return on their capital of 177.3%, which is an extraordinary figure, particularly as the analyst is forecasting long-term return on capital of 13.2%. So what level of reinvestment would be sensible? Well, let's divide long-term growth by the forecast return on capital.

And this tells us that the company should really be reinvesting 30.3% of its profits to support that 4% growth rate.

If we now apply that 30.3% to our final year NOPAT, well we can calculate an implied free cash flow, which gives us an implied free cash flow of 9.3. If we now put that 9.3 into our free cash flow used in our terminal value calculation, boom, we can see that we have the same terminal value for both methodologies. So our terminal value now has consistency between our return on capital and our growth rate and our free cash flow forecasts.