Key features of the free cash flow approach to valuation

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Reference no: EM132252670 , Length: 2 pages

Question 1. Arget Technologies, Inc. is a leading manufacturer of bar code scanners and related information technology whose stock is traded on the New York Stock Exchange. In Year 3, the SEC filed allegations that during the previous five-year period, the company manipulated millions of dollars in revenue, net income, and other measures of financial performance. These manipulations were designed to meet financial projections driven by Wall Street expectations and were allegedly engineered and/or facilitated by the company's chief accounting officer (a CPA).

An example of the various ploys used by Target occurred in Year 1 when a Target officer and other employees created an excessive reserve of $10 million for obsolete inventory. This $10 million cushion was a "cookie jar" reserve designed for use when the company failed to meet its quarterly forecast, and it exceeded any reasonable estimate of the company's exposure for obsolete inventory. This reserve was released into earnings in the fourth quarter of Year 1. By making this and other adjustments that quarter, Target reported net income of $13.4 million rather than a $2.4 million loss and hit the quarterly forecast right on the nose. The reversal of this "cookie jar" inventory reserve and the favorable impact on reported earnings were not disclosed to the public.

Requirement:
Identify the ethical issues involved with the "cookie jar" reserves and the economic consequences for parties affected by the chief accounting officer's actions. (Hint: Reference the AICPA's Code of Professional Conduct for CPAs).

Question 2. Although the exact definition of "free cash flow" varies in practice, most stock analysts, investment professionals, and valuation experts define the term as the company's operating cash flows (before interest) minus cash outlays for routine operating capacity replacement such as buildings and furnishings. In this sense, it's the amount of cash flow available to finance further expansion of operating capacity (growth), to reduce debt, to pay dividends, or to repurchase stock. Analysts sometimes include in the free cash flow measure cash outlays associated with planned growth (new retail store openings) if management has already announced the growth plans.
Please respond to the statements/questions below and reply to one other student:

1. Discuss the difference between a company's operating cash flow and its free cash flow.

2. Discuss the key features of the free cash flow approach to valuation.

3. What does the phrase sustainable earnings mean? What types of earnings are not sustainable?

4. What are abnormal earnings?

5. Discuss the key features of the abnormal earnings approach to valuation.

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Reference no: EM132252670

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