Question

Harry Carson is analyzing Tucson Corp., a manufacturing firm which follows US GAAP. He has gathered the financial information shown below in Exhibits 1, 2, and 3. Corporate income is taxed at a flat rate of 28%.

Exhibit 1: Tucson's current capital structure

	Market Value (millions)	Required return
Bonds	$500	4.0%
Common stock	$700	7.0%
Total Capital	$1,200

Exhibit 2: Selected financial data for Tucson (20X6)

	(millions)
Revenues	$1,604
Depreciation expense	$50
Interest expense	$13
Fixed capital investment	$80
Net income available to common shareholders	$145

Exhibit 3: Selected balance sheet data for Tuscon

As of 31 December (in millions)	20X6	20X5
Cash and cash equivalents	$118	$105
Accounts receivable	$265	$234
Inventories	$589	$583
Total current assets	$972	$922
Accounts payable	$74	$63
Notes payables	$70	$83
Other current liabilities	$507	$506
Total current liabilities	$651	$652

Carson then talks to his colleague, Mitchell Saunders, who forecasts that Tuscon's net income will be $160 million in 20X7 and that the following assumptions can be made for 20X7 and beyond:

• Net fixed assets will increase by 20% of net income annually
• Annual investments in working capital will be 35% net income
• Target capital structure is 70% equity, 30% debt, and no preferred stock
• Free cash flow to the firm (FCFF) will be 75% of net income and grow by 3.0% annually
• Free cash flow to equity (FCFE) will grow by 4.1% annually
• The firm's cost of equity will remain at its current level and its weighted average cost of capital will be 4.9%

Carson then asks another colleague, Wendy Pritchard, about the proper method to value the firm. Pritchard makes the following statements:

Statement 1: "Tucson pays dividends that are closely linked to its capacity to pay dividends since its Board of Directors have approved a constant dividend payout ratio policy. Therefore, free cash flow methods are preferred. Dividend discount models are invalid."

Statement 2: "Tucson’s capital structure seems unstable since it might issue a large amount of long-term debt in the next couple of years. Therefore, Tucson should use the FCFE method rather than the FCFF method to value the company."

Statement 3: "The market consensus is that a private equity firm intends to acquire a large share of Tucson stock to take control of the company. Therefore, free cash flow measures are more appropriate than dividend discount models."

Finally, while discussing alternative methods of computing free cash flow with Pritchard, Carson makes the following comment: “We must adjust for after-tax interest since interest paid is considered an operating cash flow under US GAAP. Also, Tucson has just announced that it will take more tax deductions than assumed when reporting its deferred tax asset. Tucson would most accurately estimate free cash flow by subtracting the deferred tax asset from its free cash flows.”

Questions: Are Pritchard’s statements (statement 1, 2, and 3) about valuation methodology accurate? justify

Is Carson’s comment about calculating free cash flows from operating cash flows correct? Why

Answer 1

Statement 1 is incorrect, because constant dividend policy is that which pays some percentage of earnings of a company. If company reports higher earnings, the dividend goes up and if reports lower earnings, dividends goes down. So, we can use dividend discount model for the valuation.

Statement 2 is also incorrect. If the capital structure is volatile, we cant use the FCF valuation models.

Statement 3 is correct. The one who holds a major stake, can dictate the dividend policy of the firm. Hence, Free cash flow model is used for the valuation. Dividend discount model is used for the minority shareholders.

The formula for FCFF nd FCFE are mentione below

Hence, after tax interest should be adjusted but not the deffered tax asset to arrive at the Free cash flow