Sundancis fcfe for the year 2000 is computed as

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Sundanci's FCFE for the year 2000 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 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. 18-3
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b. The FCFE model requires forecasts of FCFE for the high growth years (2001 and 2002) plus a forecast for the first year of stable growth (2003) in order to allow for an estimate of the terminal value in 2002 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 million Required return on equity (r): 14% Actual 2000 Projected 2001 Projected 2002 Projected 2003 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 2002 Terminal value = (Projected 2003 FCFE)/(r g) **Projected 2002 Total cash flows to equity = Projected 2002 FCFE + Projected 2002 Terminal value ***Discounted values obtained using r = 14% ****Current value per share = Sum of Discounted Projected 2001 and 2002 Total cash flows to equity 18-4
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c. i. 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 P/E ratio stocks with high dividend yields to be undervalued and conversely, high P/E ratio 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.
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