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Terminal Value Calculation with Constant Payout Ratio and Active Debt Management

Due to the possible deferral of capital gains taxes, retaining earnings provide a tax advantage compared to distributing them. Because of this, the calculation of the terminal value is often based on the assumption of an exogenously determined payout ratio. The present study considers this assumption and develops a valuation model for the case in which the firm pursuits an active debt management, that is, adopts a financing policy based on market values. The terminal value is determined under both free cash flow and flow to equity approaches. Overall, it is shown that the valuation formula used in standard practice does not take into account all the financial effects caused by the retention of earnings. A simulation of the valuation error highlights that the value contribution of the dividend policy is overestimated by more than 25% on average. This result points out the need to carefully rethink the currently employed approaches to terminal value calculation.