What is a critical consideration when using a perpetuity to evaluate the residual value of an acquisition?

When evaluating the residual value of an acquisition using a perpetuity, a critical consideration is that a perpetuity can create a very large residual. This arises because a perpetuity represents a stream of cash flows that is expected to continue indefinitely. When calculating the present value of this cash flow stream, the formula typically used is Cash Flow / Discount Rate. If the cash flow is substantial or if the discount rate is low, the resulting residual value can easily exceed reasonable expectations, particularly if the business does not realistically have that level of sustained cash flow.

This concept highlights the importance of carefully assessing the assumptions behind the cash flow projections and the appropriate discount rate. An overly optimistic cash flow assumption can lead to inflated valuations. Therefore, while perpetuities provide a straightforward method for determining residual value, they can also lead to significant discrepancies between projected and actual business performance.