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Sundanci's FCFE for the year 2010 is computed as follows: FCFE = Earnings after tax + Depreciation expense −Capital expenditures −Increase in NWC = $80 million + $23 million −$38 million −$41 million = $24 million
Chapter 13 - Equity Valuation 13-14 FCFE per share = FCFE/number of shares outstanding = $24 million/84 million shares = $0.286 At the given dividend payout ratio, Sundanci's FCFE per share equals dividends per share. b.The FCFE model requires forecasts of FCFE for the high growth years (2011 and 2012) plus a forecast for the first year of stable growth (2013) in order to allow for an estimate of the terminal value in 2012 based on perpetual growth. Because all of the components of FCFE are expected to grow at the same rate, the values can be obtained by projecting the FCFE at the common rate. (Alternatively, the components of FCFE can be projected and aggregated for each year.) The following table shows the process for estimating Sundanci's current value on a per share basis: Free Cash Flow to Equity Base Assumptions Shares outstanding: 84 millions Required return on equity (r): 14% Actual 2010 Projected 2011 Projected 2012 Projected 2013 Growth rate (g) 27% 27% 13% Total Per share Earnings after tax $80 $0.952 $1.2090 $1.5355 $1.7351 Plus: Depreciation expense $23 $0.274 $0.3480 $0.4419 $0.4994 Less: Capital expenditures $38 $0.452 $0.5740 $0.7290 $0.8238 Less: Increase in net working capital $41 $0.488 $0.6198 $0.7871 $0.8894 Equals: FCFE $24 $0.286 $0.3632 $0.4613 $0.5213 Terminal value $52.1300* Total cash flows to equity $0.3632 $52.5913** Discounted value $0.3186*** $40.4673*** Current value per share $40.7859**** *Projected 2012 Terminal value = (Projected 2013 FCFE)/(r −g) **Projected 2012 Total cash flows to equity = Projected 2012 FCFE + Projected 2012 Terminal value ***Discounted values obtained using r = 14% ****Current value per share = Sum of Discounted Projected 2011 and 2012 Total cash flows to equity
Chapter 13 - Equity Valuation 13-15 c.i. The following limitations of the dividend discount model (DDM) are addressed by the FCFE model. The DDM uses a strict definition of cash flows to equity, i.e. the expected dividends on the common stock. In fact, taken to its extreme, the DDM cannot be used to estimate the value of a stock that pays no dividends. The FCFE model expands the definition of cash flows to include the balance of residual cash flows after all financial obligations and investment needs have been met. Thus the FCFE model explicitly recognizes the firm’s investment and financing policies as well as its dividend policy. In instances of a change of corporate control, and therefore the possibility of changing dividend policy, the FCFE model provides a better estimate of value. The DDM is biased toward finding low PIEratio stocks with high dividend yields to be undervalued and conversely, high PIEratio stocks with low dividend yields to be overvalued. It is considered a conservative model in that it tends to identify fewer undervalued firms as market prices rise relative to fundamentals. The DDM does not allow for the potential tax disadvantage of high dividends relative to the capital gains achievable from retention of earnings.