2、Chan Mei Yee Case Scenario

Chan Mei Yee is valuing McLaughlin Corporation common shares using a free cash flow approach. She assembled information about McLaughlin from several sources. She begins her analysis by estimating free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) for the 2007 fiscal year, using the financial statements in Exhibits 1 and 2 and other financial information contained in Exhibit 3. McLaughlin’s fiscal year ends 31 December.

Chan plans to perform two different valuations of McLaughlin, which she calls the "base case" valuation and the "alternative" valuation. Critical assumptions for each are given below and in Exhibit 3.

Base case valuation

·   2008 FCFF will be $600 million.

·   FCFF will grow forever at 4% annually.

·   The market value and book value of McLaughlin’s long-term debt are approximately equal.

Alternative valuation

·   2008 earnings per share (EPS) will be $1.80.

·   EPS will grow forever at 6% annually.

·   For 2008 and beyond:

- Net capital expenditures (fixed capital expenditures minus depreciation) will be 30% of EPS.

- Investments in working capital will be 10% of EPS.

- 60% of future investments will be financed with equity and 40% will be financed with debt.

Chan is also concerned about the effects on McLaughlin’s 2008 FCFE of the following three possible financial actions by McLaughlin during the year 2008:

·   Increasing common stock cash dividends by $110 million.

·   Repurchasing $60 million of common shares.

·   Reducing its outstanding long-term debt by $100 million.

Melissa Nicosia, Chan’s supervisor, reviews the McLaughlin valuations. Nicosia states that the free cash flow valuation approach is superior to the discounted dividend valuation approach because the company’s dividends have been substantially different from its FCFE. Nicosia also states that because the company’s capital structure seems unstable, the FCFE valuation approach is superior to the FCFF valuation approach.

Exhibit 1

McLaughlin Corporation

Selected Financial Data
(millions, except per share amounts)

Exhibit 2

McLaughlin Corporation

Exhibit 3

Other Current Financial Information for McLaughlin Corp.

Question 1

McLaughlin's FCFF for 2007 was closest to:

A. $460 million.

B. $474 million.

C. $485 million.

D. $545 million.

 
Question 2

McLaughlin's 2007 FCFE was less than its 2007 FCFF by an amount closest to:

A. $74 million.

B. $126 million.

C. $326 million.

D. $386 million.

 
Question 3

Using Chan's base case valuation assumptions and the FCFF valuation approach, the year-end 2007 value per share of McLaughlin common stock should be closest to:

A. $18.25.

B. $23.73.

C. $24.89.

D. $29.20.

Question 1

McLaughlin's FCFF for 2007 was closest to:

A. $460 million.

B. $474 million.

C. $485 million.

D. $545 million.

 
Correct answer = C

"Free Cash Flow Estimation," John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey
2008 Modular Level II, Vol. 4, pp. 354-357
Study Session 12-47-d, e
discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), or cash flow from operations (CFO) to calculate FCFF and FCFE;
calculate FCFF and FCFE given a company's financial statements prepared according to U.S. Generally Accepted Accounting Principles or International Accounting Standards
FCFF = NI + NCC + Int(1 - Tax Rate) - WCInv - FCInv
FCFF = 626 + 243 + 186(1 - 0.32) - (80 - 105) - 535 = 485.48 = $485 million 

Question 2

McLaughlin's 2007 FCFE was less than its 2007 FCFF by an amount closest to:

A. $74 million.

B. $126 million.

C. $326 million.

D. $386 million.

 
Correct answer = C

"Free Cash Flow Estimation," John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey
2008 Modular Level II, Vol. 4, pp. 363-368
Study Session 12-47-d, e
discuss the appropriate adjustments to net income, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), or cash flow from operations (CFO) to calculate FCFF and FCFE;
calculate FCFF and FCFE given a company's financial statements prepared according to U.S. Generally Accepted Accounting Principles or International Accounting Standards
FCFE = FCFF - Int(1 - Tax Rate) + Net Borrowing.
FCFE = FCFF - 186(1 - 0.32) + (2,249 - 2,449) = FCFF - 126.48 - 200 = FCFF - 326.48
FCFE is approximately $326 million less than FCFF.
An alternate approach is to calculate FCFF and FCFE separately and difference them.
FCFF = NI + NCC + Int(1 - Tax Rate) - WCInv - FCInv
FCFF = 626 + 243 + 186(1 - 0.32) - (80 - 105) - 535 = 485.48 = $485 million
FCFE = NI + NCC - FCInv - WCInv + Net Borrowing
FCFE = 626 + 243 - 535 - (80 - 105) + (2,249 - 2,449) = $159 million
FCFF - FCFE = 485.48 - 159 = $326.48 million (FCFE is $326 million less) 

Question 3

Using Chan's base case valuation assumptions and the FCFF valuation approach, the year-end 2007 value per share of McLaughlin common stock should be closest to:

A. $18.25.

B. $23.73.

C. $24.89.

D. $29.20.

 
Correct answer = B

"Free Cash Flow Estimation," John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey
2008 Modular Level II, Vol. 4, pp. 352-353
Study Session 12-47-k
calculate the value of a company using the single-stage, two-stage, and three-stage FCFF and FCFE models
The value of the firm is:


Equity value = Firm value - Market value of debt = 12,000 - 2,249 = $9,751 million.
Value per share = Equity value / Number of shares = 9,751 million / 411 million = 23.7251 = $23.73 per share 

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