John E. Wall - Page 26




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          sentence makes clear, the two key variables in this approach are            
          Demco’s normalized free cash-flow and the appropriate discount or           
          capitalization rate to be used to determine the present value of            
          that cash-flow.                                                             
               In order to determine Demco’s normalized free cash-flow, Ms.           
          Walker began by adding Demco’s 1987 to 1991 pretax income to its            
          forecasted 1992 pretax income; she then divided that sum by the             
          number of years in the period (6) to arrive at an average annual            
          pretax income of $1,097,381.  Ms. Walker then made the following            
          adjustments to this average to arrive at normalized free cash-              
          flow:                                                                       
                    1.  She subtracted hypothetical income taxes at a 34-             
               percent rate.19                                                        

               18(...continued)                                                       
          term forecast for the subject company.                                      
               19 Because Demco is an S corporation, it is not subject to             
          Federal income tax and pays only a small amount of State income             
          tax.  Nevertheless, Ms. Walker computed Demco’s normalized free             
          cash-flow by subtracting a hypothetical income tax, at a 34-                
          percent rate, from Demco’s average income for 1987-92.  This is             
          referred to as “tax-effecting” Demco’s income.                              
               As Ms. Walker acknowledged in her testimony, appraisers                
          disagree on whether it is appropriate to tax-effect the income of           
          an S corporation.  The argument in favor of tax-effecting                   
          stresses that many potential buyers of S corporations are C                 
          corporations.  Because a C corporation would be unable to                   
          maintain a target company’s S corporation status following an               
          acquisition, the C corporation would tax-effect the S                       
          corporation’s income (at C corporation rates) in deciding how               
          much it would pay for the S corporation.  See Trugman,                      
          Understanding Business Valuation:  A Practical Guide to Valuing             
                                                             (continued...)           





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