General Investments is considering the purchase of a significant stake in Pacific Computer Components (PCC). Although PCC has stable production output, the company is located in a developing country with an uncertain economic environment. Since the monetary environment is particularly worrisome. General has decided to approach the valuation of PCC from a free cash flow model using real growth rates. In real rate analysis, General uses a modified build-up method for calculating the required real return, specifically:required real return = country real rate + industry adjustment +company adjustmentElias Sando, CFA, an analyst with General, estimates the following information for PCC:Domestic inflation rate = 8.738% Nominal growth rate = 12.000% Real country return = 3.000% Industry adjustmen = 3.000% Company adjustment = 2.000%Additionally, Exhibit 1 reports information from PCC's financial statements for the year just ended (stated in LC).PCC generally maintains relatively constant proportions of equity and debt financing and is expected to do so going forward.Sando has gathered information on earnings before interest, taxes, depreciation, and amortization (EBITDA) and is contemplating its direct use in another cash flow approach aimed at valuing PCC. Consider the following two statements regarding EBITDA:Statement 1: EBITDA is not a good proxy for free cash flow to the firm (FCFF) because it does not incorporate the importance of the depreciation tax shield nor does it reflect the investment in working capital or in fixed capital.Statement 2: EBITDA is also a poor proxy for FCFE. Free cash flow to the firm (FCFF) for PCC is closest to
Answer(s): C
FCFF = FCFE + Int(l - tax rate) - net borrowing = 7.3 + 5.0(1 - 0.34) - (2.4 - 2.0) = LC10.2 million, or LC10,200,000. (Study Session 12, LOS 41.e)
General Investments is considering the purchase of a significant stake in Pacific Computer Components (PCC). Although PCC has stable production output, the company is located in a developing country with an uncertain economic environment. Since the monetary environment is particularly worrisome. General has decided to approach the valuation of PCC from a free cash flow model using real growth rates. In real rate analysis, General uses a modified build-up method for calculating the required real return, specifically:required real return = country real rate + industry adjustment +company adjustmentElias Sando, CFA, an analyst with General, estimates the following information for PCC:Domestic inflation rate = 8.738% Nominal growth rate = 12.000% Real country return = 3.000% Industry adjustmen = 3.000% Company adjustment = 2.000%Additionally, Exhibit 1 reports information from PCC's financial statements for the year just ended (stated in LC).PCC generally maintains relatively constant proportions of equity and debt financing and is expected to do so going forward.Sando has gathered information on earnings before interest, taxes, depreciation, and amortization (EBITDA) and is contemplating its direct use in another cash flow approach aimed at valuing PCC. Consider the following two statements regarding EBITDA:Statement 1: EBITDA is not a good proxy for free cash flow to the firm (FCFF) because it does not incorporate the importance of the depreciation tax shield nor does it reflect the investment in working capital or in fixed capital.Statement 2: EBITDA is also a poor proxy for FCFE. The current value of PCC equity using a FCFE model is closest to:
Answer(s): A
Given the assumptions stated in the problem, this is a simple single stage valuation. Using the firm's modified build-up methodology, the real required rate of return is 8% (= country real rate + industry adjustment + firm adjustment = 3% + 3% + 2%).The real growth rate is = 3%. FCFE is LC7.3000.000 from Question 61. Hence, the value of PCC equity is:(Study Session 12, LOS 4l.k)
General Investments is considering the purchase of a significant stake in Pacific Computer Components (PCC). Although PCC has stable production output, the company is located in a developing country with an uncertain economic environment. Since the monetary environment is particularly worrisome. General has decided to approach the valuation of PCC from a free cash flow model using real growth rates. In real rate analysis, General uses a modified build-up method for calculating the required real return, specifically:required real return = country real rate + industry adjustment +company adjustmentElias Sando, CFA, an analyst with General, estimates the following information for PCC:Domestic inflation rate = 8.738% Nominal growth rate = 12.000% Real country return = 3.000% Industry adjustmen = 3.000% Company adjustment = 2.000%Additionally, Exhibit 1 reports information from PCC's financial statements for the year just ended (stated in LC).PCC generally maintains relatively constant proportions of equity and debt financing and is expected to do so going forward.Sando has gathered information on earnings before interest, taxes, depreciation, and amortization (EBITDA) and is contemplating its direct use in another cash flow approach aimed at valuing PCC. Consider the following two statements regarding EBITDA:Statement 1: EBITDA is not a good proxy for free cash flow to the firm (FCFF) because it does not incorporate the importance of the depreciation tax shield nor does it reflect the investment in working capital or in fixed capital.Statement 2: EBITDA is also a poor proxy for FCFE. Suppose that PCC initiates a cash dividend, with a target payout ratio of 25% of net income. What is the likely magnitude of the effect of the new cash dividend and the net change in the outstanding debt on future FCFE, all else equal?
Dividend policy change: A change in dividend policy will have no direct impact on future FCFE. Note that dividend payments arc a use of equity cash flows, not a reduction in FCFE. It is possible that an increase in dividends could reduce the long-term growth rate of the firm, thus reducing firm value. However, holding all other factors constant, an increase in dividends will not affect FCFE forecasts.Net change in debr. The increase in debt, LC400.000, will increase future interest expense and decrease future FCFE, but the amount is small relative to net income of LC7,000,000. {Study Session 12, LOS 4l.h)
General Investments is considering the purchase of a significant stake in Pacific Computer Components (PCC). Although PCC has stable production output, the company is located in a developing country with an uncertain economic environment. Since the monetary environment is particularly worrisome. General has decided to approach the valuation of PCC from a free cash flow model using real growth rates. In real rate analysis, General uses a modified build-up method for calculating the required real return, specifically:required real return = country real rate + industry adjustment +company adjustmentElias Sando, CFA, an analyst with General, estimates the following information for PCC:Domestic inflation rate = 8.738% Nominal growth rate = 12.000% Real country return = 3.000% Industry adjustmen = 3.000% Company adjustment = 2.000%Additionally, Exhibit 1 reports information from PCC's financial statements for the year just ended (stated in LC).PCC generally maintains relatively constant proportions of equity and debt financing and is expected to do so going forward.Sando has gathered information on earnings before interest, taxes, depreciation, and amortization (EBITDA) and is contemplating its direct use in another cash flow approach aimed at valuing PCC. Consider the following two statements regarding EBITDA:Statement 1: EBITDA is not a good proxy for free cash flow to the firm (FCFF) because it does not incorporate the importance of the depreciation tax shield nor does it reflect the investment in working capital or in fixed capital.Statement 2: EBITDA is also a poor proxy for FCFE. Under the assumption that PCC maintains relatively constant proportions of equity and debt financing, the most appropriate valuation model is the:
Answer(s): B
Since the company's capital structure is reasonably stable and FCFE is positive, FCFE is a simpler approach to valuation than FCFF, EVA, or residual income, and is preferred in this case. (Study Session 11, LOS 41 .b and Study Session 12, 41.b)
General Investments is considering the purchase of a significant stake in Pacific Computer Components (PCC). Although PCC has stable production output, the company is located in a developing country with an uncertain economic environment. Since the monetary environment is particularly worrisome. General has decided to approach the valuation of PCC from a free cash flow model using real growth rates. In real rate analysis, General uses a modified build-up method for calculating the required real return, specifically:required real return = country real rate + industry adjustment +company adjustmentElias Sando, CFA, an analyst with General, estimates the following information for PCC:Domestic inflation rate = 8.738% Nominal growth rate = 12.000% Real country return = 3.000% Industry adjustmen = 3.000% Company adjustment = 2.000%Additionally, Exhibit 1 reports information from PCC's financial statements for the year just ended (stated in LC).PCC generally maintains relatively constant proportions of equity and debt financing and is expected to do so going forward.Sando has gathered information on earnings before interest, taxes, depreciation, and amortization (EBITDA) and is contemplating its direct use in another cash flow approach aimed at valuing PCC. Consider the following two statements regarding EBITDA:Statement 1: EBITDA is not a good proxy for free cash flow to the firm (FCFF) because it does not incorporate the importance of the depreciation tax shield nor does it reflect the investment in working capital or in fixed capital.Statement 2: EBITDA is also a poor proxy for FCFE. Are the statements concerning EBITDA correct or incorrect?
Boih statements arc correct. EBITDA is in fact a poor proxy for FCFF because it does not incorporate the cash taxes paid by the firm. EBITDA also fails to reflect the investment in working capital and the investment in fixed capital. EBITDA is an even worse proxy for FCFE than as a proxy for FCFF. EBITDA does not reflect after-tax interest costs or other cash flows that shareholders care about, such as new borrowing o the repayment of debt. (Study Session 12, LOS 41.i)
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