Final answer:
The terminal firm value at year 5 in a two-stage firm valuation model is the free cash flow at year 6 divided by the difference between the WACC and the growth rate (g). This reflects the ongoing value of the firm beyond the initial forecast period.
Step-by-step explanation:
In the two-stage firm valuation model, the terminal firm value at year 5 is calculated as the free cash flow at year 6 divided by the difference between the Weighted Average Cost of Capital (WACC) and the growth rate (g). This corresponds to option a): terminal firm value at year 5 equals to free cash flow at year 6 divided by (WACC - g rate). This formula assumes that starting from year 6, the firm's cash flows will grow at a constant rate indefinitely.
The terminal value is an important component of the valuation model because it accounts for a significant portion of the firm's overall value, capturing the present value of all future free cash flows beyond the initial forecasting period, under the assumption that the business will continue to generate cash flows at a stable growth rate.