- 26 -
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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