Question #34

It is common to capitalize and amortize research and development (R&D) expenses and add R&D expenses back to earnings. Deferred taxes are eliminated to pick up only cash taxes. Operating leases are treated as capital leases. (Module 23.1, LOS 23.a) Geremiah Analytics provides litigation consulting services to the intellectual property industry. They specialize in patent infringement liability and software valuation. Mariah Hofstedt, CFO of Geremiah, projects that the firm will earn $3 million pre-tax income this year. Additional selected financial data on Geremiah are presented below. Table 1: Selected Financial Data for Geremiah Analytics Total assets $40 million Debt/assets 60% Average coupon on debt 8% Cost of equity 12% Tax rate 40% Hofstedt has not been happy with the firm's financial performance. She would like to increase return on equity (ROE) and improve revenue growth, and is considering various ways to deploy Geremiah's cash flow in order to meet these two goals. One possibility is using some of Geremiah's cash flow to make a strategic acquisition. Hofstedt has been looking at a smaller boutique firm, Logiciels LaMarre, which provides consulting services to the software industry. Hofstedt and a Geremiah Analytics valuation team have performed a preliminary valuation on Logiciels LaMarre using a free cash flow to equity (FCFE) model. However, Theodore LaMarre, CEO of Logiciels LaMarre, is not pleased with the resultant valuation that Geremiah has placed on his firm. Rather than argue about the inputs of the free cash flow (FCF) model, LaMarre takes the position that FCFE is an inappropriate model for valuing Logiciels LaMarre. He cites the firm's rapid growth and resultant need for capital investment as reasons that valuing the firm on projections of FCFE is not reliable. LaMarre wants Geremiah to value Logiciels LaMarre using the residual income approach. LaMarre asserts, "The fact that our terminal value can be calculated with a high degree of certainty makes the use of a residual value model more appropriate than use of a FCFE model." Hofstedt counters that the residual income approach is not in LaMarre's interest. She points out, "Value tends to be recognized later in a residual income approach than in a FCFE approach." There is, however, one point on which LaMarre and Hofstedt agree. They both recognize that competitive forces in the industry will drive the current high ROE of Logiciels LaMarre down to the cost of equity capital over time. Hofstedt concludes, "Given the assumption of a decline in ROE, we should use a persistence factor between zero and one." LaMarre disagrees, saying, "The assumption about ROE means that the present value of the continuing residual income at Logiciels LaMarre is the current residual income divided by the cost of equity capital.