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 4

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

A. $18.00.

B. $22.80.

C. $24.17.

D. $25.20.

 
Question 5

The combined effect of the three possible financial actions is most likely to result in a decrease in McLaughlin's 2008 FCFE of:

A. $100 million.

B. $160 million.

C. $170 million.

D. $270 million.

 
Question 6

Are Nicosia's explanations correct with respect to the:

A. Answer A.

B. Answer B.

C. Answer C.

Question 4

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

A. $18.00.

B. $22.80.

C. $24.17.

D. $25.20.

 
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. 353, 363-364
Study Session 12-47-f, k
discuss approaches for forecasting FCFF and FCFE;
calculate the value of a company using the single-stage, two-stage, and three-stage FCFF and FCFE models
FCFE = Net income - (1 - DR)(FCInv - Depreciation) - (1 - DR)(WCInv)
FCFE₁ = 1.80 - (1 - 0.40)(0.30 x 1.80) - (1 - 0.40)(0.10 x 1.80)
FCFE₁ = 1.80 - 0.324 - 0.108 = 1.368
FCFE will grow at the same rate as Net income, 6% annually.

The value per share is $22.80 

Question 5

The combined effect of the three possible financial actions is most likely to result in a decrease in McLaughlin's 2008 FCFE of:

A. $100 million.

B. $160 million.

C. $170 million.

D. $270 million.

 
Correct answer = A

"Free Cash Flow Estimation," John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey
2008 Modular Level II, Vol. 4, pp. 363-364
Study Session 12-47-h
explain how dividends, share repurchases, share issues, and changes in leverage may affect FCFF and FCFE
The three possible actions are: dividend increase = 110; share repurchase = 60; and the debt repayment = 100. Reducing debt by $100 million reduces FCFE (the amount of cash available to equity holders) by that amount. The cash dividend and the share repurchase are uses of FCFE and do not change the amount of cash available to equity holders. 

Question 6

Are Nicosia's explanations correct with respect to the:

A. Answer A.

B. Answer B.

C. Answer C.

D. Answer D.

 
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. 375-380
Study Session 12-47-c, n
contrast the ownership perspective implicit in the FCFE approach to the ownership perspective implicit in the dividend discount approach;
describe the characteristics of companies for which the FCFF model is preferred to the FCFE model
Analysts should use free cash flow valuation whenever dividends differ significantly from the company's capacity to pay dividends. FCFF valuation is preferred over FCFE valuation whenever the capital structure is unstable or ever-changing. So Chan's first statement is correct, and her second statement is incorrect. 

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