CASE: REESE CAMPBELL CASE SCENARIO (331)

Reese Campbell is an equity analyst at triad investment management (TIM), an asset management firm that offer investment products to private wealth and institutional clients. Campbell is evaluating the appropriateness of several investments to include in their aggressive equity fund, a fund that has a mandate of achieving high returns by investing in risky ventures.

Campbell is currently evaluating the financial value of capital enterprises. Capital enterprises is a manufacturing and trading firm with a current free cash flow to the firm of $350 million. Based on its target capital structure, the firm will constitute of 30 percent debt. CE´s cost of debt is 6.4%, and based on the riskiness of its cash flows, its equity investors require a return of 12.2%.

Campbell has estimate that the company FCFF would grow at a long-term growth rate of 4.5%. The current market value of de company´s debt is $1.3 billion, and the firm has 150 million shares outstanding. The tax rate is 37%.

Campbell is examining the financial statement of emergent technologies (ET), a technology firm incorporated in 2006 with an initial investment in fixed capital of $700,000. Exhibit 1 and 2 display some information from the financial statements of the firm for three years following incorporation (the figures given are in thousands)

Campbell is planning to use the statement of cash flow of a distributing firm to estimate the free cash flow to the firm and free cash flow to equity. However, Campbell knows that the effects of different accounting standards related to the cash flow statement must be kept in mind before proceeding with the calculations. For clarification, Campbell approached Jeremiah Bret, her supervisor at the firm. Bret made the following comments:

Statement 1: «To estimate FCFF starting with FCO, the treatment of interest must be kept in mind. Although the U.S. GAAP treats interest paid or received as operating activities, the IFRS treats them as either operating or financing activities»

Statement 2: «The value of a firm can be estimated by discounting FCFF using the WACC calculated on a pre-tax basis. However, for this, the FCFF should be computed by adding back interest paid with no tax adjustment».

Bret is estimating the FCFF of SkyHigh Manufacturing Ltd. (SHM), a firm that earned a net income of $310,000 over the most recent year. The firm underwent corporate restructuring a few years ago and the net income includes an amount of $50,000 resulting from a reversal of a previous accrual. In addition, the firm has recorded a gain of $30,000 from the sale of its equipment, and has amortized long-term bond discounts in the amount of $55,000. Some of the financial information for the current year is provided in Exhibit 3. The company has a tax rate of 30%.

While talking to Campbell about her analysis, Bret made the following comment:

“The FCFF could also be calculated using the firm´s EBIT and EBITDA amounts. However, there is one slight difference in using these two amounts as a starting point for calculating FCFF.”

1. Capital Enterprises value per share is closest to:

1. $56.57
2. $35.78
3. $37.78

 2. The FCFF (in thousands) of Emergent Technologies  for the year 2008 is closest to:

1. $205.052
2. $144.572
3. $110.092

 3. The FCFF (in thousands) of Emergent Technologies  for the year 2009 is closest to:

1. $239.30
2. $222.072
3. $210.753

 4. Bret is most accurate whit respect to:

1. Statement 1 only
2. Statement 2 only
3. Both statement 1 and 2

 5. The FCFF for SkyHigh Manufacturing Ltd for the current year is closest to:

1. $16,000
2. $26,000
3. $  6,000

 6. The difference in estimating FCFF using EBIT versus using EBITDA as a starting point is most likely related to the handling of:

1. Interest
2. Depreciation
3. Taxes

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